THE 

ARTHUR  YOUNG 

ACCOUNTING 

COLLECTION 


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Accounting 

Practice  and  Procedure 


BY 

SIR  ARTHUR  LOWES  DICKINSON 

M.A.  Cantab,  CEHTiriiD  Public  Accountant,  Fellow  or 

THE  Institute  or  Chartered  Accountants,  Fellow 

or  the  Institute  or  Actuaries,  Member  or 

THE  Firm  or  Price,  Watkrhousk  &  Co. 


Sixth  Printing 
NEW  YORK 

THE  RONALD  PRESS  COMPANY 
1920 

40056 


Copyright,  1913,  by 
Arthur  Lowes  Dickinson 


Copyright,  1918,  by 
Arthur  Lowes  Dickinson 


All  rights  reserved 


HF 


PREFACE  Ublu 

N  The  profession  of  accountancy  is  at  a  great  disadvantage 

4  in  comparison  with  that  of  law,  by  reason  of  the  fact  that  the 
7  decisions  reached  on  the  important  questions  which  arise 
CO  from  day  to  day  are  not  publicly  rendered  and  available  as 
V  authorities  for  the  rest  of  the  profession,  but  are  made 
y      privately  and  as  a  rule  are  accessible  only  to  a  few. 

In  issuing  this  volume,  therefore,  it  is  my  hope  that  the 
record  it  contains  of  some  of  the  problems  encountered  in 
^  the  course  of  twenty-five  years  of  practice  on  both  sides  of 
|K  the  Atlantic  may  be  of  value  to  my  fellow  accountants  and 
*s  may  in  some  measure  serve  to  discharge  some  part  of  the 
*,  debt  I  owe  to  the  profession  to  which*  I  belong. 
^  The  first  eight  chapters  deal  with  probleme  relating  to 

the  income  account  and-  balance  sheet.    These  are  followed 
by  one  on  some  problems  involved  in  cost  accounting ;  while 
the  last  chapter  deals  with  the  accountant's  responsibility  to 
;J      the  public — a  subject  that  is  becoming  more  important  every 
■^      day. 

It  has  been  my  endeavor  to  avoid  technicalities  and  so 
to  render  the  book  useful  to  the  student  entering  the  pro- 
fession and  also  to  lawyers,  bankers  and  professional  men 
generally,  who  are  vitally  interested  in  accounting  but  have 
not  had  the  accountant's  training. 

In  my  practice  it  has  been  my  good  fortune  to  be  in  close 
touch,  in  partnership  and  otherwise,  with  many  leading 
practitioners  both  in  the  United  States  and  England,  and 
in  association  with  them  to  deal  with  many  of  the  problems 
herein  discussed,  so  that,  while  the  responsibility  for  the 
views  expressed  is  solely  mine,  the  value  they  may  possess 
is  drawn  from  wider  sources. 

A.  Lowes  Dickinson. 
October  lo,  19 13. 

iii 


(fit 


p 


PREFACE   TO   FOURTH    PRINTING 

The  author  has  taken  advantage  of  the  present  reprint 
to  omit  some  few  forms  which  have  become  obsolete  or  of 
but  little  value,  and  to  make  one  or  two  other  changes 
necessary  to  bring  the  book  up  to  date. 

With  the  exception  of  these  omissions  and  substitu- 
tions— which  are  not  important — no  change  has  been  made 
in  the  text. 

A.  Lowes  Dickinson 
November  i,  191 8. 


ir 


CONTENTS 


Chapter  I.    Bookkeeping 

Double-Entry  Bookkeeping 

Impersonal  Accounts 

Function  of  Impersonal  Accounts 

Opening  the  Books 

The  Trial  Balance 

Early  Bookkeeping  Methods 

The  Subsidiary  Ledger 

Controlling  Accounts 

Loose-Leaf  Records 

Mechanical  Aids  in  Bookkeeping 

Modern  Bookkeeping  Methods — Pro  Forma  System 

(1)  Sales  and  Customers  Records 

(2)  Cash  Records 

(3)  Passing  Bills  for  Payment 

(4)  Creditors  or  Purchase  Records 

(5)  Expense  and  Cost  Accounts 

(6)  Journal  Entries 

(7)  General  Ledger  Accounts 
Progress  of  Bookkeeping 

Chapter  II.    The  Balance  Sheet 

Balance  Sheet  an  Approximation 
Causes  Affecting  Net  Worth 
Balance  Sheet  Accounts 
Form  of  Balance  Sheet 
Order  of  Assets  and  Liabilities 

V 


VI  CONTENTS 

Analysis  of  Balance  Sheet  Assets 

(1)  Fixed  Assets 

(2)  Permanent  Investments 

(3)  Investment  of  Reserves 

(4)  Working  Assets 

(5)  Current  Assets 

(6)  Suspense  Debits 

Analysis  of  Balance  Sheet  Liabilities 

Capital  Stock 

Funded  and  Unfunded  Debt 

Current  Liabilities 

Depreciation 

Suspense  Credits 

Surplus 

Appropriated  Surplus 

Profit  and  Loss 

English  Requirements   as  to  Balance  Sheet 

Balance  Sheet  Forms 

Misleading  Statements  in  Balance   Sheets 

Condensed  Financial  Statement 

Statutory  Forms  of  Balance  Sheet 

Chapter  IIL    The  Profit  and  Loss  Account  and  the 
General  Principles  Governing  Its  Preparation 

Loss  and  Gain  Terminology 

Varying  Purposes  of  Financial  Statements 

Classification  of  Activities 

(1)  Manufacturing 

(2)  Merchandising 

(3)  Agency  and  Commission 

(4)  Transportation 

(5)  Banking 

(6)  Professional  Activities 

(7)  Private  Accounts 
Suggested  Terminology 

Forms  for  Statements  of  Loss  and  Gain 

Items  Properly  Chargeable  to  Profit  and  Loss 

Nature  of  Profits 

Single-Entry  Determination  of  Profits 

Corporate  Profits 

Corporate  Profits — English  Rule 

Corporate  Profits — American  Rule 

Corporate  Profits — General  Rule 


CONTENTS  vu 

Chapter  IV.    Balance  Sheet  Assets 
I.    CAPITAL  ASSETS 

(1)  Fixed  i'ROPERTY 
Land  and  Improvements 
Buildings  and  Structures 

Plant,  Machinery  and  Fixed  Tools 
Movable  Equipment 
Furniture  and  Fixtures 
Patterns,  Drawings,  Dies,  etc. 
Patents,  Goodwill  and  Franchises 
Changes  in  Value  of  Capital  Assets 

(2)  Permanent  Investments 
Investments  for  Purposes  of  Control 
Investments  Controlling  Facilities  or  Output 
Minor  Investments 

Non-Income  Producing  Investments 
Advances 

(3)  Investment  of  Reserves 

II.  WORKING  ASSETS   , 

(1)  Stores  and  Supplies 

(2)  Advances  to  Agents 

(3)  Expenses  Incurred  in  Advance  of  Accrual 

Chapter  V.     Balance  Sheet  Assets  (Continued) 

III.  CURRENT  ASSETS 

(1)     Stocks  on  Hand 

Essentials  for  Ascertaining  Correct  Profits 
Taking  the  Inventory- 
Cost  Accounting 
Distribution  of  Expense  Burden 
Allocation  of  Expenses 

Selling  Expenses  as  Part  of  Manufacturing  Cost 
Status  of  Interest 

Increasing  Value  of  Seasoning  Material 
Treatment  of  Carrying  Charges 
Profits  on  Work  in  Progress 
Reserves  for  Contingencies 


vin  CONTENTS 

Book  Inventories 

Physical  Verification  of  Book  Inventories 

Monthly  Charges 

Contracts  of  Purchase 

Inventory  Credits  and  Liabilities 

Accuracy  of  Inventory  Valuations 

(2)  Accounts  and  Bills  Receivable 

Present  Values  of  Accounts  and  Bills  Receivable 

(3)  Investments 
Unissued  Stock  or  Bonds 

Issued  Stock  or  Bonds  Held  in  Treasury 
Valuation  of  Investments 

(4)  Cash 

Cash  on  Current  Account 
Outstanding  Checks 
Restricted  Cash  Balances 

(5)  Foreign  Exchange 
Dealings  in  Foreign  Exchange 

Chapter  VI.     Balance  Sheet  Liabilities 

(1)  Capital  Stock 

Capita]  Stock  Without  Par  Value 
Redemption  of  Capital  Stock 
Treasury  Stock 
Treasury  Stock — English  Rule 

(2)  Bonded  Debt 

Effective  Interest  Rate  of  Bonds 

Annual  Income  Charges 

Varying  Conditions  Affecting  Annual  Charge 

Methods  of  Determining  Charge  to  Income 

Operation  of  the  Various  Methods  of  Determining  Annual  Charge 

to  Income 
Determining    Annual    Charge    When    Proportionate    Discount    is 

Written   Off 
Discount  on  Bond  Issues  Not  a  Proper  Charge  to  Capital 

(3)  Available  Capital  Resources 

(4)  Current  Liabilities 

(5)  Contingent  Liabilities 


CONTENTS  IX 

(6)  Sinking  Fund  Reserves  for  Redemption  of  Debt 

(7)  Other  Provisions  or  Appropriations 

(8)  Secret  Reserves 


Chapter  VII.     Repairs,  Renewals,  Depreciation  and  New 
Construction 

(1)  Property  Expenditures 
Classification 
Reconstruction  and  Improvements 

Interest  and  Overhead  Charges  in  Capital  Outlay 
Profits  on  Construction  Work  Not  Permissible 

(2)  Maintenance  Expenditures 

Treatment  of  Maintenance  Expenditures  by  Railroads 
Classification  of  Maintenance  Expenditures 

(3)  Renewals   and  Depreciation 
General  Considerations 

(4)  Methods  of  Providing  for  Depreciation 
Annuity  Method 

Straight  Line  Method 

Diminishmg  Balance  Method 

Combination  Method 

Treatment  of  Interest  on  Accumulated  Depreciation 

Exhaustion  of  Minerals 

Amortization  of  Leaseholds 

Conclusion 

Chapter  VIII.    Special  Points  in  Corporation  Accounting 
and  Finance 

(1)  Accounting  for  Holding  Companies 

The  Consolidated  Balance  Sheet  and  Income  Account 

Legal  Status  of  Consolidated  Balance  Sheet 

Intercompany  Profits  and  Accounting 

What  is  a  Constituent   Company? 

Other  Forms  of  Consolidated  Statements 

(2)  Profits  Earned  Before  Date  of  Consolidation 

(3)  Questions  Arising  on  the  Organization  of  a  Corporation 
Initial  Surplus 

Losses  on  Current  Assets  Acquired 

Adjustment   of   Inventories   on   Purchase   and   Sale   of   a   Business 


X  CONTENTS 

Chapter  IX.    Some  Theories  and  Problems  in  Cost 
Accounting 

Nature  of  Plant 

Constituent  Elements  of  Cost 

Conditions  Affecting  Cost 

Purposes  of  Cost  Accounting 

Constituent  Elements  of  Commercial  Costs 

Distribution  of  Overhead  Expense  ' 

Selling  Costs 

Importance  of  Accurate  Cost  Keeping 

Relation  of  Interest  and  Rent  to  Manufacturing  Cost 

Nature  of  Commercial  Investments 

Interest  and  Rent  Not  a  Manufacturing  Cost 

Rental  Charges 

Difficulties  of  Including  Interest  as  a  Manufacturing  Cost 

Suggested  Treatment  of  Interest  in  Connection  with  Costs 

Statistical  Comparisons  Between  Production  and  Capital  Invested 

Profit-sharing  in  Its  Relation  to  Costs 

Cost  as  a  Price  Basis 

Chapter  X.    The  Duties  and  Responsibilities  of  the  Public 
Accountant 

(1)  In  Respect  of  the  Prospectus 
Necessity  for  Accountants'  Certificates 
English  Requirements  as  to  Prospectuses 
Period  to  Be  Covered  by  Prospectus 
Treatment  of  Unusual  Profits  or  Losses 
Fluctuations  of  Profits 

Results  for  Broken  Periods 

Interest  in  Its  Relation  to  Profits 

Salaries  as  Affecting  Profits 

Depreciation  and  Renewals  in  Their  Relation  to  Profits 

Varying  Requirements  of  Statements  of  Profits 

Adjustments 

Estimates  of  Anticipated  Economies 

Estimates  of  Future  Earnings 

Certificate  of  Financial  Condition 

Certificate  of  Profits  Without  Certificate  of  Assets 

Liability  of  Certifying  Accountant 

(2)  In  Respect  of  Audit 
Audit  Practice  in  England 

American  and  English  Practice  as  to  Company  Audits 


CONTENTS 

Canadian  Audit  Practice 

Accountant's  Responsibility  for  Audit  Certificates 

Qualified  Certificates 

Accountant's  Moral  and  Legal  Responsibility 

(3)     In  Respect  of  Liquidation  and  Reconstruction 
Responsibility  of  Accountant  in  Case  of  Business  Failure 
Causes  or  Conditions  Leading  Up  to  Insolvency 
Reorganization 


Appendix 

I.  Sections  of  the  English  Law  Relating  to  the  Inspection  and 
Audit  of  Accounts  [Companies  (Consolidation)  Act, 
1908]. 

II.    Extracts    from    Schedule    I    to    Companies    (Consolidation) 
Act,  1908,  Known  as  Table  A. 

III.  Sections    of    the    English    Law    relating    to    Prospectuses 

[Companies  (Consolidation)  Act,   1908]. 

IV.  Sections   of  the   English  Law  Relating  to  Payment  of  In- 

terest  Out  of  Capital  [Companies    (Consolidation)  Act, 
1908]. 

V.  Sections  Relating  to  Shareholders'  Audit  in  the  Canadian 
Bank  Act,  1913. 

VI.     Form  of  General  Balance  Sheet  Statement  as  Prescribed  by  the 
Interstate  Commerce  Commission  for  Steam  Roads. 

VII.    Tentative  Form  of  Balance  Sheet  Proposed  by  Federal  Reserve 
Board  for  Merchants  and  Manufacturers. 


ACCOUNTING 

Practice  and   Procedure 


CHAPTER  I 

BOOKKEEPING 

Bookkeeping  is  the  essential  foundation  of  accounting, 
and  a  thorough  knowledge  of  its  elementary  principles  and 
general  methods  is  necessary  to  the  proper  understanding 
of  accounting  principles.  While,  therefore,  it  is  not  within 
the  scope  of  the  present  book  to  put  forth  an  exhaustive 
treatise  on  bookkeeping,  it  will  serve  a  useful  purpose  to 
devote  some  space  to  a  consideration  of  the  principles  in- 
volved and  to  modern  methods  of  carrying  these  principles 
into  effect. 

Double-Entry  Bookkeeping 

The  term  "bookkeeping"  is  commonly  and  loosely  used 
to  describe  any  method  of  entering  accounts  of  transactions 
in  money,  but  the  only  scientific  system  which  is  worth 
notice  here  is  that  known  as  "double-entry  bookkeeping," 
which  is  based  on  the  fact  that  every  transaction  involves  a 
transfer  of  property  or  its  equivalent  from  one  person  to 
another,  the  terms  "property"  and  "person"  being  used  in 
the  widest  possible  sense.    This  operation  of  receiving  and 

13 


14      ACCOUNTING    PRACTICE    AND    PROCEDURE 

giving  is  expressed  in  bookkeeping  by  the  use  of  the  terms 
"debit"  and  "credit"  which  may  be  thus  defined : 

A  person  is  debited  with  whatever  is  received  from 
another. 

A  person  is  credited  with  whatever  is  transferred  to 
another. 

Every  debit  necessarily  involves  a  corresponding  credit, 
and  after  any  number  of  transactions  have  been  thus  en- 
tered it  follows  that  the  sum  of  all  the  debits  will  exactly 
equal  the  sum  of  all  the  credits. 

Impersonal  Accounts 

It  is  customary  in  treatises  on  bookkeeping  to  draw  a 
somewhat  sharp  line  of  distinction  between-  a  personal  and 
an  impersonal  account,  meaning  by  the  first  an  account  kept 
with  some  definite  person  or  group  of  persons  whether  cor- 
porate or  otherwise,  and  by  an  impersonal  account  one  which 
expresses  merely  a  condition.  In  effect,  however,  all  imper- 
sonal accounts  are  merely  subdivisions  of  the  personal 
account  of  the  person  or  group  of  persons  by  or  for  whom 
the  accounts  are  kept,  who  may  briefly  be  termed  the  "prin- 
cipal." These  accounts  are  devised,  according  to  modern 
ideas,  not  so  much  for  the  purpose  of  determining  the  finan- 
cial relation  of  the  principal  to  those  with  whom  he  deals 
(although  of  course  this  is  important)  as  to  show  his  own 
incomings  and  outgoings,  possessions  and  obligations,  in 
such  full  detail  as  will  enable  him  best  to  control  his  affairs 
and  to  determine  his  own  financial  position. 

Function  of  Impersonal  Accounts 

The  demands  of  bookkeeping  would  be  satisfied  if  A, 
carrying  on  a  business,  debited  himself  with  all  he  received 
and  credited  himself  with  all  he  parted  with,  correspondingly 


BOOKKEEPING 


IS 


crediting  and  debiting  those  from  whom  he  received 
and  to  whom  he  transferred.  In  such  a  case  all  his 
side  of  the  transactions  would  be  merged  in  one  account 
only  in  his  books;  and  a  very  detailed  analysis  of  this  ac- 
count, and  a  complete  inventory  of  all  his  property  and 
assets,  would  be  required  to  furnish  information  of  his  own 
position,  either  as  to  profits  or  capital. 

In  order  to  furnish  continuously  this  detailed  analysis, 
impersonal  or  nominal  accounts  so-called  have  been  intro- 
duced, and  the  principle  of  debit  and  credit  has  been  applied 
to  them  as  if  they  were  persons.  Such  accounts  may,  there- 
fore, be  considered  as  a  continuous  and  daily  analysis  of  the 
principal's  own  account;  or,  from  another  aspect,  may  be 
treated  as  a  division  of  his  personality  into  a  number  of 
pockets,  each  one  of  which  represents  some  specific  part  of 
his  activities,  and  the  gathering  together  of  all  of  which  will 
represent  his  condition.  It  is  in  this  gathering  together  of 
impersonal  accounts  that  bookkeeping  passes  the  imaginary 
dividing  line  that  separates  it  from  accounting.  The  bal- 
ancing of  the  conditions  surrounding  each  one  of  these 
accounts,  and  the  determination  of  the  exact  bearing  of 
each  upon  the  position  of  the  principal,  is  the  duty  of  ac- 
counting. The  problems  involved  in  the  determination  of 
the  value  in  money  to  be  placed  upon  each,  form  the  main 
subject  of  this  volume. 

Opening  the  Books 

On  the  principles  already  outlined  the  principal  first 
distributes  all  his  property  to  various  imaginary  locations, 
crediting  himself  as  the  transferor,  and  debiting  the  locali- 
ties, each  of  which  has  a  suitable  name,  such  as  Land,  Build- 
ings, Investments,  Cash,  etc.,  with  what  each  receives  in  this 
imaginary  distribution.     Similarly,  he  credits  himself  with 


l6      ACCOUNTING    PRACTICE    AND    PROCEDURE 

amounts  received  by  other  individuals  from  him  which  at 
this  stage  represent  debts  owing  to  him,  and  debits  himself 
with  what  he  has  received  from  other  individuals  which  also 
represents  debts  owing  by  him  to  them.  When  this  distri- 
bution is  completed  in  his  books  the  sum  of  all  the  debits, 
now  representing  various  classes  of  property  and  debtors, 
must  exactly  equal  the  sum  of  all  credits  representing  cred- 
itors and  his  own  account,  this  latter  showing  his  capital  or 
worth  in  gross  while  all  the  remaining  accounts,  both  debit 
and  credit,  show  of  what  this  worth  is  composed.  This 
process,  which  is  generally  known  as  "opening  the  books,"  is 
followed  by  an  exactly  similar  record  of  each  subsequent 
transaction,  each  being  debited  and  credited  to  the  particular 
account  concerned,  whether  Property,  or  Debtor,  or  Creditor. 
In  the  same  way  amounts  due  to  others  from  himself  for 
use  of  their  facilities  or  due  to  him  by  others  for  their  use 
of  his  facilities  (such  as  rent,  interest,  wages,  etc.)  are 
debited  or  credited  to  accounts  in  his  books  representing 
his  outgoings  or  incomings  under  their  various  headings, 
other  than  property,  and  credited  or  debited  to  the  other 
parties  to  the  transactions. 

The  Trial  Balance 

At  any  stage  the  same  equation  between  the  sums  of 
all  debits  and  all  credits  should  exist  if  the  entries  have 
all  been  made  with  clerical  accuracy,  so  far  as  the  two  sides, 
debit  and  credit,  are  concerned.  Errors  due  to  debits  or 
credits  being  made  to  a  wrong  account  cannot  be  detected  by 
this  means,  but  require  a  critical  re-examination  of  each 
entry,  a  process  which  is  essential  at  some  time  before  a 
final  balance  is  reached.  This  equation  of  debits  and  credits 
is  known  as  a  Trial  Balance,  and  its  main  object  is  to  prove 
the  clerical  accuracy  of  the  work  and  to  form  a  basis  for  the 
further  critical  examination  required. 


BOOKKEEPING 


17 


The  methods  by  which,  under  modern  conditions,  tiiis 
equation  between  debits  and  credits  is  reached  are  of  con- 
siderable importance. 

Early  Bookkeeping  Methods 

The  old-fashioned  routine  of  bookkeeping  was  as 
follows : 

Firstly,  a  record  was  made  in  a  book  known  as  a  "Day 
Book"  of  each  transaction  as  it  occurred,  e.g. — 

"Bought  100  tons  of  pig  iron  from  B  at  $15 

per  ton. 
Accepted  B's  draft  for  $i,5(X>." 

and  so  on. 

Secondly,  the  entries  in  the  day  book  were  converted 
into  a  form  specifying  the  accounts  which  should  be  debited 
and  credited  in  each  particular  case,  known  as  "journal- 
izing" the  entry  from  the  fact  that  this  was  entered  in  a 
book  known  as  a  "Journal,"  e.g. — 

Pig  Iron,  Dr.  $1,500 

To  B.,  Cr.  $1,500 

For  100  tons  of  pig  iron 
at  $15  per  ton. 


B.,  Dr.  $1,500 

To  Bills  Payable,  Cr.  $1,500 

For  B's  draft  accepted  this  day. 

Thirdly,  each  side  of  each  entry  in  this  journal  would 
be  entered,  or  "posted,"  to  a  debit  (left-hand)  or  credit 
(right-hand)  page  in  a  third  book  called  a  "Ledger,"  headed 
with  the  account  name  shown  in  the  journal  entry,  so  com- 
pleting the  record. 


l8      ACCOUNTING    PRACTICE    AND    PROCEDURE 

As  business  developed  it  was  found  that  if  this  elemen- 
tary process  were  applied  to  a  business  of  any  magnitude, 
the  work  involved  would  be  enormous;  and  accordingly  it 
became  customary  to  group  transactions  of  similar  charac- 
ter so  that  in  the  ledger  the  totals  only  of  a  number  of 
similar  transactions  might  be  dealt  with. 

The  most  important  elementary  examples  of  such  group- 
ing are  found  in  the  "Cash  Book"  and  the  "Sales  Day 
Book,"  which  contain  characteristics  of  both  the  day  book 
and  the  ledger  of  our  first  example.  The  cash  book  is  in 
itself  in  its  common  form  a  ledger  account  for  cash,  which 
from  the  fact  that  it  is  easily  counted  and  balanced  in  money 
values,  a  quality  possessed  by  no  other  kind  of  property, 
came  to  be  considered  of  some  special  importance.  This 
ledger  account  of  cash,  therefore,  instead  of  being  written 
up  or  posted  from  the  day  book  to  the  journal,  and  the 
journal  to  the  ledger,  came  to  be  used  as  a  book  of  original 
entry,  in  place  of  the  day  book,  for  all  cash  transactions, 
whether  incoming  or  outgoing,  the  other  half  of  the  entry 
being  obtained  by  posting  each  individual  item  directly  from 
the  cash  book  to  the  ledger,  thus  eliminating  altogether  the 
intermediate  journal.  In  the  case  of  the  sales  day  book  a 
similar  method  was  adopted,  all  sales  being  entered  in  a  sei>- 
arate  day  book,  the  items  being  posted  directly  to  the  ac- 
counts of  the  customers  and  the  total  to  the  credit  of  the 
sales  account,  thus  again  completing  the  double  entry  and 
entirely  eliminating  the  journal. 

The  Subsidiary  Ledger 

As  business  increased  in  volume,  so  the  opportunity  for 
clerical  error  in  carrying  transactions  through  the  various 
books  and  the  consequent  difficulty  of  obtaining  an  accurate 
trial  balance  also  increased,  and  attempts  were  made  at  sec- 


BOOKKEEPING 


19 


tional  balancing  by  which  portions  of  the  ledger  might  be 
proved  and  balanced  without  the  necessity  of  dealing  with 
the  whole.  This  was  applied  firstly  to  the  sales,  which  af- 
fected only  a  certain  class  of  accounts.  The  ledger  was 
divided  into  two  portions,  one  of  which  contained  only 
customers'  accounts  •  the  debits  to  these  accounts  came  from 
the  sales  day  book,  and  the  credits  were  obtained  by  employ- 
ing a  separate  cash  book  or  a  separate  column  in  the  general 
cash  book  for  all  amounts  received  from  customers,  the  totals 
of  which  were  carried  into  the  general  cash  book  or  "gen- 
eral" column  of  the  cash  book  at  fixed  intervals.  By  making 
separate  summaries  of  the  sales  day  book  and  sales  column  in 
the  cash  book,  and  by  also  keeping  a  separate  list  of  all  dis- 
counts allowed  on  customers'  accounts,  all  the  debits  and 
credits  which  affected  the  sales  ledger  could  be  put  together 
and  balanced  with  the  totals  of  that  ledger  independently  of 
any  other  part  of  the  books.  Then  it  was  found  simpler, 
and  more  conducive  to  accuracy,  to  take  the  totals  of  all  the 
individual  entries  and  put  them  through  the  journal,  which 
had  fallen  into  disuse,  these  totals  being  posted  to  an  ac- 
count in  the  main  part  of  the  ledger  or  "General  Ledger" 
with  some  such  title  as  "Customers  Account"  or  "Sales 
Ledger  Account." 

The  process  thus  shortly  described  may  be  more  clearly 
shown  by  an  example : 

(i)  A  customers'  ledger  contains  accounts  with  100 
different  individuals,  showing  on  January  ist  a  number  of 
balances,  or  debts,  due,  aggregating  say  $1,500. 

(2)  During  the  month  of  January  sales  are  made  to 
various  customers,  each  of  which  is  entered  in  the  day  book 
as  made  and  subsequently  posted  to  the  debit  of  some  account 
in  the  customers  ledger  (i).  The  day  book  at  the  end  of 
January  is  added  up  and  the  total  found  to  be  $10,000. 


20      ACCOUNTING    PRACTICE    AND    PROCEDURE       • 

(3)  During  the  month  of  January  collections  are  made 
from  customers,  and  entered  individually,  as  received,  in  a 
book,  and  posted  to  the  credit  of  the  corresponding  account 
in  the  ledger  (i).  As  these  postings  are  made  a  note  is 
made  in  the  cash  book,  against  the  cash  receipt,  of  the 
amount  of  discount  allowed.  At  the  end  of  the  month  the 
cash  and  discount  items  are  separately  added  up  and  found 
to  amount  to  $10,200  and  $300  respectively. 

(4)  At  January  31st  the  balances  on  the  customers 
ledger  (i)  are  again  taken  off  and  found  to  amount  to 
$1,000,  and  it  is  desired  to  know  whether  or  not  this  is  the 
correct  amount. 

(5)  The  proof  is  as  follows: 

Balances  at  January  ist  (i)  $  1,500 

Add — Sales  for  month  (2)  10,000 


Total        $11,500 
Deduct: 
Cash   received    (3)  $10,200 

Discount  allowed  (3)  300       10,500 


Balance  should  be  and  is   (4)       $  1,000 

The  following  would  be  specimen  journal  entries  for 
such  a  group  of  transactions : 

Customers  Account,  Dr.      $10,000 

To  Sales  Account,  $10,000 

For  total  of  sales  for  the 
month  as  shown  by 
sales  day  book,  p. — 


BOOKKEEPING  2I 

Discount  allowed,  Dr.  300 

To  Customers  Account,  300 

For  discounts  allowed  to 
customers  during  the 
month  as  per  discount 
day  book  (usually  a 
separate  memorandum 
column  in  sales  cash 
book). 


Cash  Account,  Dr.  10,200 

To  Customers  Account,  10,200 

For  cash  received  from 
customers  during  the 
month. 

Controlling  Accounts 

From  the  nature  of  these  entries  it  will  be  seen  that  all 
debits  and  credits  which  have  been  posted  individually  to  the 
accounts  in  the  customers  ledger  have  also  been  posted  in 
total  through  the  above  entries  to  the  Customers  account  in 
the  general  ledger,  and  that  consequently  the  balance  on 
the  latter  account  must  always  equal  the  sum  of  all  balances 
in  the  former  ledger. 

Accounts  such  as  "Customers  Account"  above-men- 
tioned are  known  as  "controlling  accounts,"  and  their  use 
is  now  common  in  all  large  concerns  and  is  applied  not 
merely  to  sales  but  to  any  group  of  accounts  of  sufficient 
magnitude  to  make  such  a  course  desirable.  Their  use 
necessitates  a  number  of  subsidiary  books  or  subsidiary  col- 
umns in  principal  books,  each  one  representing  some 
separate  controlling  account  or  even  some  subdivision  of  such 
an  account.  The  elementary  example  just  given,  which  in- 
volves nothing  but  simple  arithmetic  and  common  sense,  is 


22       ACCOUNTING    PRACTICE    AND    PROCEDURE 

typical  of  all  such  controlling  systems  and  no  other  prin- 
ciple is  involved  therein. 

Loose-Leaf  Records 

Up  to  this  point  only  bound  books,  in  which  all  the  neces- 
sary entries  were  made,  have  been  considered.  As  the  mag- 
nitude of  business  concerns  increased,  further  subdivisions 
became  necessary  if  the  accounts  were  to  be  kept  reasonably 
up  to  date.  This  was  at  first  accomplished  by  dividing  sub- 
sidiary books  into  two  or  more  portions  for  use  on  alternate 
days  as  books  of  original  entry;  and  in  the  intervening 
periods  for  posting  and  other  bookkeeping  purposes.  This 
method  served  the  purpose  for  a  long  period  and  is  still  con- 
siderably used.  Progressive  minds,  however,  advanced  the 
idea  of  using  loose  sheets  for  original  record,  which  after 
transfer  of  the  information  to  the  final  books  of  account, 
i.e.,  the  ledgers,  were  bound  up  and  filed  away  for  reference 
purposes;  and  this  process  has  been  extended  very  largely 
to  subsidiary  ledgers  and  under  suitable  precautions  even  to 
principal  ledgers.  In  the  offices  of  banks  and  brokers  and 
other  similar  institutions  the  original  entry  frequently  con- 
sists of  a  rough  memorandum  on  a  small  piece  of  paper. 
These,  known  as  "tickets,"  have  by  the  end  of  the  day 
served  all  their  bookkeeping  purposes  and  are  filed  away  in 
bundles  for  reference  if  need  be.  It  would  be  thought  that 
such  methods  must  lead  to  a  large  increase  in  errors,  but  in 
practice  this  is  not  found  to  be  the  case,  while  the  time  saved 
is  undoubtedly  very  great.  The  fact  that  by  these  methods 
the  work  is  segregated  and  each  class  of  entry  grouped  under 
the  supervision  of  one  clerk  who  is  thoroughly  familiar  with 
it  and  has  at  short  intervals  to  prove  and  balance  his  portion 
of  the  work,  has  conduced  to  greater  care  and  accuracy ;  and 


BOOKKEEPING 


^Z 


the  loss  of  any  portion  of  a  loose  original  record  before 
at  least  one  side  of  it  has  found  a  more  permanent  abiding 
place,  is  very  rare. 

Mechanical  Aids  in  Bookkeeping 

Various  mechanical  devices  have  gradually  come  into 
considerable  use  in  bookkeeping,  such  as  adding  machines ; 
combined  typewriter  and  calculating  machines ;  book  type- 
writers, etc. ;  all  of  which  have  entirely  revolutionized  book- 
keeping methods  as  they  formerly  existed,  and  while  they 
do  not  call  for  a  high  order  of  intelligence  on  the  part  of 
those  who  are  responsible  for  subsidiary  records,  they 
require  something  a  good  deal  beyond  a  mere  knowledge  of 
bookkeeping  on  the  part  of  those  who  control  and  interpret 
the  final  processes  and  results. 

Modern  Bookkeeping  Methods — Pro  Forma  System 

The  following  pro  forma  system  illustrates  modern  book- 
keeping methods  now  in  common  use,  without  giving  effect 
to  many  further  refinements,  particularly  in  the  use  of  more 
mechanical  devices  which  already  find  a  limited  but  ever- 
extending  use  in  large  accounting  organizations. 

(i)  Sales  and  Customers  Records 

Invoices  to  customers  for  sales  made  are  typewritten  in 
multiple  copies,  of  which  one  copy  is  sent  to  the  customer 
and  another  forms  the  sales  record.  These  are  totalled 
periodically  by  means  of  an  adding  machine  after  they  have 
been  individually  posted  to  the  debit  of  the  customers  account 
in  the  usual  loose  leaf  or  card  ledger.  The  totals  of  the 
adding  machine  slips  form  the  basis  of  a  journal  entry  pre- 
pared on  a  loose-leaf  form  entitled  "journal  voucher,"  and 
debiting  "Customers  Ledger  Account"  and  crediting  the 
"Sales  Account."  Generally  there  will  be  two  or  more  cus- 
tomers ledgers  arranged  for  different  groups  of  initial  let- 


24 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


ters,  such  as  A  to  E ;  F  to  L ;  M  to  O ;  P  to  S ;  T  to  Z,  the 
invoice  forms  in  use  for  each  being  either  printed  on  a  dif- 
ferent colored  paper  or  bearing  some  distinctive  reference 
mark.  These  invoice  forms  are  sorted  out  by  ledgers,  sep- 
arate totals  made  of  each  on  an  adding  machine,  and  a  sep- 
arate controlling  account  kept  for  each  ledger,  either  in  the 
general  ledger  or  in  a  separate  subsidiary  ledger  which  is 
itself  controlled  by  one  Customers  Ledger  account  on  the 
general  ledger.  In  more  refined  systems  the  invoice  and  the 
entry  on  the  debit  of  the  customers  account  are  made  at  one 
writing  by  means  of  a  book-typewriter ;  and  a  tabulating  ma- 
chine attached  gives  the  total  of  all  invoices  automatically. 

Detailed  analyses  of  sales,  which  are  now  required  in 
most  businesses,  will  frequently  be  made  by  means  of  an 
electric  sorting  and  tabulating  machine,  based  upon  cards 
punched  in  such  manner  as  to  record  thereon  all  the  salient 
facts  on  the  original  invoice. 

Credits  to  customers'  accounts  are  handled  in  an  exactly 
similar  manner  to  the  debits,  the  debits  and  credits  being  of 
course  reversed. 

Cash  receipts  for  sales  will  be  entered  up,  as  they  are 
received,  on  a  loose  sheet  which  contains  separate  columns 
for  cash  items  and  discount  items  corresponding  to  each  cus- 
tomers ledger;  or  in  a  very  large  business  the  remittances 
will  be  first  sorted  by  ledgers  and  those  relating  to  each 
ledger  entered  on  a  separate  sheet.  The  daily  totals  of  these 
sheets  will  be  handed  to  the  chief  cashier  after  the  sheets  are 
completed,  and  by  him  agreed  with  an  adding  machine  slip 
of  the  remittances  which  he  has  received  and  paid  to  bank, 
and  will  then  be  entered  in  his  general  cash  book  in  separate 
totals  for  each  customers  ledger.  The  cash  sheets  will  be 
sent  by  the  entering  clerk  to  the  ledger  clerks,  who  post  the 
items  into  the  corresponding  customers  ledgers  and  at  the 
same  time  enter  on  sheets  and  ledgers  the  corresponding  dis- 


BOOKKEEPING 


25 


counts.  The  sheets  are  then  sent  to  the  treasurer  for  filing- 
in  permanent  binders,  where  they  are  always  available  for 
reference.  Frequently  the  postings  of  debits  and  credits  to 
customers'  accounts  are  taken  off,  totalled  and  balanced  daily 
with  the  adding  machine  lists  of  sales,  cash  sheets  and  credit 
slips  so  as  to  insure  a  correct  balance  of  the  customers 
ledgers  at  the  end  of  the  month. 

(2)  Cash  Records 

The  daily  totals  of  cash  received  from  customers  as 
shown  upon  the  subsidiary  sheets  are  entered  on  the  prin- 
cipal cash  book  together  with  all  other  general  items. 
This  book  is  sometimes  provided  with  separate  analysis 
columns  under  frequently  recurring  headings  and  with  a 
column  for  each  bank  in  which  the  daily  payments  into  bank 
are  entered.  If  the  bank  accounts  are  numerous  only  one 
column  is  kept  in  the  principal  cash  book  for  payments  into 
banks,  and  this  is  supported  by  a  subsidiary  book  containing 
a  separate  column  for  each  bank  in  which  debits  and  credits 
are  entered  in  totals  each  day  from  the  additions,  on  a  bank 
paying-in  slip,  of  the  receipts  and,  on  stubs  of  cheque  books, 
of  the  payments ;  the  sum  of  the  totals  of  all  columns  on  this 
subsidiary  book  should  always  agree  with  the  total  bank 
balance  as  shown  by  the  principal  cash  book.  The  best  ac- 
counting practice  provides  for  all  receipts  being  paid  into 
bank  daily;  any  loose  cash  required  being  provided  by  a 
fixed  sum  in  the  hands  of  the  cashier,  which  is  replenished 
as  often  as  may  be  necessary  by  cheques  drawn  for  the  total 
disbursements  made  thereout. 

Liabilities  are  usually  paid  by  what  is  known  as  a 
"voucher  cheque"  or  by  a  voucher  against  which  a  cheque 
is  drawn.  A  typical  form  of  such  a  voucher  contains 
space  at  the  top  for  name  and  particulars  of  account ;  in  the 
centre  for  details  of  bills  supported  by  original  invoices  and 


26      ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  total  payable;  and  at  foot  for  signatures  of  the  various 
officials  whose  duty  it  is  to  pass  the  same  for  payment.  On 
the  back  will  be  found  a  "card"  or  list  of  accounts  to  one  or 
more  of  which  the  items  on  the  voucher  are  chargeable,  this 
list  forming  a  complete  distribution  of  the  voucher.  Against 
the  voucher  when  completed  the  cashier  will  issue  a  cheque ; 
which  very  frequently  forms  an  integral  part  of  the  voucher 
and  the  whole  document  then  becomes  a  voucher  cheque. 

(3)  Passing  Bills  for  Payment 

The  most  usual  and  approved  routine  through  which 
these  documents  go  before  they  are  finally  issued  to  the 
creditor  is  as  follows :  Bills  or  invoices  are  rendered  by 
the  shipper  and  are  received  by  a  designated  official;  upon 
receipt  they  are  immediately  despatched  to  the  department 
which  receives  the  goods  or  has  incurred  the  expense,  and 
are  there  certified  as  to  the  due  receipt  of  the  goods  or 
services  and  as  being  correct  as  to  quantity  and  quality. 
The  invoice  is  then  sent  to  the  official  by  whom  the  order 
was  given,  who  certifies  that  it  is  in  accord  with  the  order 
given  and  that  the  price  is  correct.  It  is  then  returned  to 
the  accounting  department  where  all  calculations  are  checked 
and  it  is  filed  under  the  supplier's  name,  attached  to  an 
"Invoice  Card"  on  which  the  amount  of  the  bill  is  also 
entered.  Sometimes  daily  reports  are  made  by  the  ordering 
and  receiving  departments  to  the  accounting  department  of 
all  goods  ordered  or  received,  and  the  verification  of  the  in- 
voice is  made  in  the  latter.  At  the  end  of  the  month,  or 
perhaps  at  more  frequent  intervals,  all  the  invoices  for  each 
supplier  are  entered  on  the  voucher,  proper  discounts  de- 
ducted and  the  voucher  sent,  with  the  original  bills  attached, 
to  the  head  of  the  consuming  department  for  a  general  cer- 
tification. The  whole  docket  then  returns  to  the  chief  ac- 
countant, who  enters  it  in  his  voucher  record,  certifies  the 


BOOKKEEPING  27 

voucher,  and  forwards  it  without  the  supporting  bills  to  the 
cashier  or  treasurer  for  payment. 

(4)  Creditors  or  Purchase  Records 

The  voucher  record  to  which  reference  has  already  been 
made,  is,  as  will  be  seen,  ruled  in  columns  and  is  a  self- 
balancing  book,  the  first  cash  column  being  the  total  amount 
due  to  the  creditor  and  being  followed  by  distribution  col- 
umns arranged  according  to  the  accounts  which  may  be  re- 
quired. This  book  is  frequently  very  bulky  and  much  time 
and  labor  is  saved  by  having  it  in  loose-leaf  form  and  in 
several  sections,  the  leaves  as  completed  being  filed  in  binders 
one  for  each  section.  The  double  entry  is  obtained  in  the 
general  ledger  by  posting  the  total  of  the  first  column  to  the 
credit  of  an  account  entitled  "Vouchers  Payable"  and  the 
totals  of  each  of  the  analysis  columns  to  the  debit  of  the  re- 
spective accounts  affected. 

The  detail  items  in  the  creditors  column  are  sometimes 
again  posted  to  the  credit  of  accounts  for  each  creditor  in  a 
subsidiary  ledger,  exactly  as  in  the  case  of  sales ;  and  in  such 
cases  the  payments  are  similarly  dealt  with,  being  entered 
up  on  separate  sheets  as  the  cheques  are  issued,  the  totals 
of  these  sheets  carried  daily  into  the  general  cash  book  and 
the  discounts  also  entered  in  the  special  discount  column  on 
the  sheets.  More  frequently,  however,  no  ledgers  are  kept 
for  creditors'  accounts ;  but  the  voucher  record  is  itself  pro- 
vided with  a  column  in  which  the  payments  are  entered, 
often  even  this  being  dispensed  with  and  the  date  of  pay- 
ment only  being  noted.  In  this  case  the  voucher  record  is 
itself  the  ledger,  and  the  open  items  at  the  end  of  any  month 
taken  off  on  an  adding  machine  will  agree  with  the  balance 
on  the  vouchers  payable  account  in  the  general  ledger.  An 
index  is  provided  for  the  voucher  record  by  which  any  in- 
dividual account  can  readily  be  found ;  and  this  index  serves 


28   ACCOUNTING  PRACTICE  AND  PROCEDURE 

as  a  reference  for  all  the  supporting  data  which  are  num- 
bered to  correspond  with  the  voucher. 

(5)  Expense  and  Cost  Accounts 

The  vouchers  are  chargeable  to  either  Property,  Oper- 
ating or  Expense  accounts,  which  are  represented  by  cor- 
responding columns  in  the  voucher  record. 

The  labor,  material  and  factory  expense  items  which 
enter  into  the  cost  of  the  product  in  a  manufacturing  busi- 
ness are  often  entered  in  a  single  column  of  the  voucher 
record  and  posted  to  an  account  in  the  general  ledger  headed 
"Cost  Ledger"  or  some  similar  designation.  The  detailed 
items  will  be  carried  into  the  cost  accounts  from  the  original 
data  before  they  reach  the  voucher  register.  Any  cost  sys- 
tem worth  the  name  arrives  with  a  considerable  degree  of 
accuracy  at  the  cost  of  goods  sold,  which  may  be  described 
as  the  output  of  the  cost  ledgers.  In  the  general  ledger  the 
account  controlling  these  cost  ledgers  is  accordingly  credited 
with  the  cost  of  all  goods  sold  during  the  month,  an  account 
styled  "Cost  of  Sales"  being  debited.  It  follows  that  the 
Cost  Ledger  account  not  only  forms  a  controlling  account 
over  the  cost  ledgers,  but  itself  represents  the  amount  sunk 
in  goods,  finished  or  partly  finished,  and  in  materials  and 
supplies  used  in  their  manufacture.  This  account  therefore 
forms  what  is  known  as  a  continuous  or  running  book  in- 
ventory, a  term  to  which  full  reference  will  be  made  in  a 
subsequent  chapter.  It  is  only  necessary  here  to  note  that 
the  accuracy  of  this  book  inventory  depends  upon  that  of  the 
item  "Cost  of  Sales"  which  forms  the  credit  to  the  account, 
and  this  again  is  entirely  dependent  on  the  substantial  ac- 
curacy of  the  system  in  force  for  ascertaining  costs. 

On  account  of  the  number  of  expense  accounts  required 
it  is  often  customary  to  keep  a  separate  subsidiary  ledger, 
or  analysis  book  as  it  is  sometimes  called,  corresponding  to 


BOOKKEEPING  29 

one  expense  column  only  in  the  voucher  record,  this  ledger 
being-  posted  from  the  original  data  before  they  reach  the 
voucher  itself,  as  in  the  case  of  cost  data.  The  correspond- 
ing expense  account  in  the  general  ledger  is  a  controlling 
account  over  this  expense  ledger  or  expense  analysis  book. 

(6)  Journal  Entries 

So  far  it  will  be  seen  that  little  use  has  been  made  of  a 
journal,  the  totals  for  cash  book  and  general  ledger  being 
posted  monthly  directly  from  subsidiary  books.  Such  a  plan 
is  frequently  adopted  in  practice ;  but  in  other  cases  each  of 
these  totals  is  made  the  subject  of  a  journal  entry  in  form 
similar  to  those  given  on  pages  20,  21.  The  adoption  of 
this  plan  is  perhaps  more  theoretically  correct  but  in  practice 
it  is  not  found  to  result  in  greater  accuracy.  A  journal  is, 
however,  still  necessary  for  special  entries,  correction  entries, 
and  other  miscellaneous  matters  which  do  not  fall  within  the 
scope  of  any  of  the  books  or  forms  described.  For  all  such 
entries  it  is  usual  to  prepare  vouchers  similar  to  the  cash 
vouchers  already  mentioned,  each  being  certified  by  the 
proper  official.  Frequently  these  journal  vouchers  are  pre- 
pared in  the  form  of  journal  entries  and  postings  are  made 
direct  therefrom.  It  should  be  noted  that  while  they  have 
reference  primarily  to  the  general  ledger,  if  the  general 
ledger  account  affected  is  a  controlling  account,  an  additional 
posting  is  also  necessary  to  some  account  in  the  controlled 
ledger,  and  this  would  usually  be  made  direct  from  the 
voucher  before  the  latter  is  entered  in  the  journal  itself. 
The  omission  of  such  double  postings  is  a  frequent  source 
of  error  in  balancing  books. 

(7)  General  Ledger  Accounts 

It  will  be  seen  that  by  the  use  of  subsidiary  records  the 
accounts,  in  the  general  ledger  are  reduced  to  comparatively 


30      ACCOUNTING    PRACTICE    AND    PROCEDURE 

few  in  number,  each  representing  some  general  class  of  ac- 
count, and  undoubtedly  the  ideal  form  of  general  ledger,  not 
perhaps  very  frequently  found  in  practice,  would  contain 
only  one  account  corresponding  to  each  heading  in  the 
periodical  balance  sheet  and  to  the  main  headings  in  the 
Income  account.  A  trial  balance  taken  off  such  a  ledger 
would  therefore  provide,  by  the  simple  process  of  putting 
down  totals,  a  balance  sheet  and  summarized  Income  ac- 
count. The  use  of  such  figures,  however,  without  a  period- 
ical examination  of  all  the  subsidiary  records  and  a  proof 
that  the  latter  are  in  agreement  with  the  corresponding 
accounts  in  the  principal  ledger,  is  a  course  not  to  be  recom- 
mended. 

Progress  of  Bookkeeping 

The  rapid  sketch  of  a  modern  bookkeeping  system  here 
given  must  not  be  considered  as  by  any  means  exhaustive, 
and  is  in  fact  only  intended  to  show  in  a  general  way  the 
advance  that  has  been  made  of  late  years  in  general  methods. 
Progress  in  this  direction  is  continuous  and  rapid,  particu- 
larly in  the  direction  of  a  greater  use  of  mechanical  devices 
which  eliminate  causes  of  error  and  minimize  the  skill  and 
knowledge  required  by  the  human  element.  This  is  perhaps 
unfortunate  in  that  it  does  not  call  for  a  higher  but  rather 
a  lower  order  of  intelligence  on  the  part  of  the  majority  of 
the  clerks  employed,  but  it  is  in  line  with  progress  in  other 
fields;  and,  as  in  those  fields,  it  demands  the  exercise  of 
higher  faculties  on  the  part  of  those  directing  the  work  and 
interpreting  the  results.  It  is  to  the  latter  that  a  clear  con- 
ception of  the  fundamental  principles  involved  in  the  most 
complicated  system  of  bookkeeping  is  of  vital  importance; 
and  experience  shows  again  and  again  that  the  key  lies  in 
the  short  phrase  "Every  debit  must  have  a  credit." 


CHAPTER  II 

THE  BALANCE  SHEET 

The  objective  of  a  set  of  books  kept  on  sound  principles 
and  with  accuracy  is  to  enable  the  actual  financial  condition 
to  be  ascertained  at  any  time.  This  condition  is  evidenced 
by  the  values  of  both  property  owned  and  debts  due,  which 
are  together  generally  described  as  assets ;  the  actual  or  esti- 
mated value  of  all  liabilities;  the  surplus  of  one  over  the 
other,  which  represents  the  net  worth  or  value ;  and  a  sum- 
mary of  the  operations  by  which  this  net  worth  has  been 
either  created,  increased  or  diminished. 

Balance  Sheet  An  Approximation  1'   a/l^  P 

It  is  generally  claimed  that  a  balance  sheet  must  represent 
facts,  but  in  the  strict  sense  this  is  not  altogether  possible  in 
any  case  that  can  be  imagined. 

K  an  individual  possessing  a  certain  definite  amount  of 
cash  embarks  this  cash  in  various  ventures  which  are  all  in 
due  course  liquidated,  with  the  result  that  at  the  close  of  all 
his  operations  he  finds  himself  with  another  definite  amount 
of  cash  either  greater  or  less  than  that  with  which  he  started, 
then  he  knows  exactly  what  his  profit  or  loss  has  been  during 
the  intervening  period.  But  such  a  condition  is  an  almost 
impossible  one  in  practice  except  as  applied  to  individual 
transactions. 

31 


32   ACCOUNTING  PRACTICE  AND  PROCEDURE 

A  contractor  may  embark  on  a  large  piece  of  construction 
work,  purchasing  with  cash  all  materials  and  supplies  re- 
quired; carry  through  his  contract  and  at  the  close  sell  off 
all  the  residue  for  cash ;  he  then  knows  exactly  what  his 
.position  is  as  regards  this  one  contract.  In  practice,  how- 
ever, before  one  contract  is  completed,  another  is  begun 
and  plant  and  material  used  for  the  first  are  not  sold  but  are 
transferred  to  the  second,  so  that  his  activities  form  a  con- 
tinuous series  of  overlapping  operations  which  may  never 
come  to  an  end  or  at  any  rate  not  for  a  long  period  of  years. 
In  the  meantime  he  desires  from  time  to  time  to  ascertain 
as  far  as  he  can  what  his  position  is  and  how  his  contracts 
are  working  out,  and  he  must  for  this  purpose  endeavor  to 
put  some  value  upon  all  his  assets  and  probably  estimate 
most  of  his  liabilities. 

Consequently,  it  follows  that  a  balance  sheet  can  only 
be  an  approximation  to  facts,  the  degree  of  approximation 
depending  upon  the  skill  and  accuracy  with  which  the  esti- 
mates are  made.  The  first  necessary  step  to  such  an  ap- 
proximation is  the  summary  of  debits  and  credits  taken  from 
the  books  of  account,  generally  known  as  a  trial  balance. 
The  trial  balance  is  the  work  of  the  bookkeeper,  while  the 
conversion  of  this  trial  balance  into  a  substantially  accurate 
financial  estimate  of  position,  or  balance  sheet,  is  the  work  of 
the  accountant.  Assuming  that  such  balance  sheets  have 
been  prepared  at  different  periods,  each  showing  as  at  the 
date  on  which  it  was  prepared  the  net  worth  of  the  in- 
dividual or  group  concerned,  then  a  comparison  of  the  dif- 
ference between  the  total  of  the  assets  and  the  total  of  the 
liabilities  at  any  two  separate  dates  shows  the  progress 
made  during  the  period  either  upwards  or  downwards.  This 
figure,  however,  by  itself  does  not  tell  the  story  of  the  in- 
tervening period  but  merely  shows  the  relative  conditions 
at  its  beginning  and  end. 


THE    BALANCE    SHEET  33 

Causes  Affecting  Net  Worth 

The  change  shown  in  the  net  worth  may  be  dne  to  any 
or  all  of  the  following  causes : 

( 1 )  Appreciation  or  depreciation  in  the  estimated  values 
of  the  property  or  assets  not  in  any  way  due  to  the  activities 
or  expenditures  of  the  individual  or  group  concerned,  such 
as  changes  in  value  of  land  due  to  greater  or  less  demand, 
or  to  discoveries  of  minerals;  and  in  values  of  buildings, 
machinery  or  commodities  due  to  a  rise  or  fall  in  prices  of 
labor  and  material  since  they  were  acquired. 

(2)  Capital  brought  into  or  drawn  out  of  the  business 
during  the  period. 

(3)  Gifts  of  property  of  any  kind  by  or  to  the  concern, 
not  in  any  way  connected  with  its  business  activities. 

(4)  Loss  or  gain  arising  from  the  excess  or  deficiency 
of  ordinary  expenditures  made  on  trading  or  manufacturing 
as  compared  with  the  income  from  the  sale  of  products. 

(5)  Loss  or  gain  arising  from  excess  or  deficiency  of 
ordinary  expenditures  on  personal  matters  as  compared  with 
income  from  personal  sources,  such  as  interest  on  stocks  or 
bonds,  or  rents. 

In  any  complete  system  of  bookkeeping  the  changes  due 
to  these  various  causes  will  be  clearly  shown  by  a  careful 
examination  of  the  accounts  kept,  the  last  two  groups  being 
those  most  difficult  of  ascertainment  in  full  detail. 

Balance  Sheet  Accounts 

In  a  general  ledger,  such  as  has  already  been  outlined, 
an  account  would  be  kept  for  each  generic  group  of  assets 
and  liabilities,  and  a  balance  account  generally  known  as 
the  "Profit  and  Loss  Account"  or  the  "Surplus  Account" 
would  include  all  other  items.  This  account  would  be  sup- 
ported by  such  subsidiary  accounts  as  might  be  necessary, 
either  kept  in  the  same  ledger  and  closed  periodically  into 


34      ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  Profit  and  Loss  account,  or  kept  in  a  subsidiary  ledger  or 
ledgers  controlled  by  the  Profit  and  Loss  account. 

Form  of  Balance  Sheet 

The  following  may  be  given  as  a  specimen  of  a  balance 
sheet  designed  to  show  the  financial  position  in  considerable 
detail  and  yet  in  a  simple  and  understandable  form: 

ASSETS:* 

Fixed  Property  (after  deduction  of  estimated  depreciation  due  to 
use): 
Land  and  improvements  thereon,  including  mineral  rights  and 

development  thereof,  but  not  structures  of  any  kind. 
Buildings  and  structures. 

Plant,  machinery,  fixed  tools,  permanent  way  for  railroad,  etc. 
Movable  equipment. 
Furniture  and  fixtures. 
Patterns,  drawings,  dies,  etc. 
Patents,  goodwill,  franchises,  etc. 

Permanent  Investments  in  stocks,  shares,  bonds  or  obligations 
of  any  kind  held  to  produce  income  or  other  increment,  or  for 
purposes  connected  with  the  business  (if  any)  carried  on,  in- 
cluding advances  made  for  similar  purposes  but  excluding  in- 
vestment of  reserves. 

Investment  of  Reserves, 

Working  Assets: 

Stores  and  supplies  for  use  in  operations. 
Advances  to  agents  for  business  expenses  and  purposes. 
Insurance,  interest,  taxes,  royalties,  etc.,  paid  in  advance  of  the 
period  over  which  they  accrue. 

Current  Assets: 

Materials  carried  for  sale  or  conversion  and  products  partly  or 
wholly  manufactured  intended  for  sale. 

Accounts  and  bills  due  from  outside  parties  for  goods  supplied 
or  short  term  advances  made,  and  recoverable  in  cash,  or  its 
equivalent  in  some  other  class  of  current  assets. 

Investments  in  securities  of  any  kind  held  as  a  temporary  em- 
ployment of  surplus  cash. 


•See  Chapters  IV  and  V  for  detailed  discussion  of  balance  sheet  assets. 


L^  r 


THE     BALANCE    SHEET 


35 


Cash  at  banks  on  deposit  and  current  account,  and  cash  on 
hand. 

Suspense  Debits: 

Consisting  of  discount  on  bonds,  expenses  of  organization  or 
other  extraordinary  losses  or  expenses  which  it  is  desired  to 
write  off  to  Income  account  over  a  period  of  years. 

LIABILITIES:* 

On  Capital  Account: 
Partners'  capital  (in  a  private  business). 
Capital  stock  (in  a  corporation). 

Loans  secured  by  mortgage  or  otherwise  and  running  for  terms 
of  years,  otherwise  known  as  "Funded  Debt." 

On  Unfunded  Debt: 
For  capital,  as  distinct  from  current,  purposes. 

Current  Liabilities: 

On  current  bank  loans  and  commercial  paper: 
Secured. 
Unsecured. 

On  trade  bills  payable. 

On  trade  accounts  payable. 

On  miscellaneous  accounts  payable. 

Accrued  interest,  taxes  and  other  periodical  payments. 

Provision  for  losses  actually  incurred,  the  amount  of  which  is 
not  definitely  ascertained. 

Provision  for  contingencies  likely  to  arise  out  of  past  opera- 
tions. 

Suspense  Credits: 
Consisting  of  items  which  will  eventually  become  credits  to 
Income  or  Surplus  but  cannot  be  at  present  adjusted. 

Surplus: 

Appropriated  to  meet  future  contingencies  which  have  not  yet 
arisen. 

Appropriated  for  repayment  of  debt  (by  sinking  fund  or  other- 
wise). 

Appropriated  for  capital  expenditures. 

Appropriated  to  equalize  dividends. 

Profit  and  Loss  account — being  undistributed  or  unappropriated 
balance  of  profits  (or  losses). 


*See  Chapter  VI  for  detailed  discussion  of  balance  sheet  liabilities. 


36      ACCOUNTING    PRACTICE    AND    PROCEDURE 

Order  of  Assets  and  Liabilities 

Much  discussion  has  taken  place  in  the  past  as  to  whether 
a  balance  sheet  should  be  drawn  up  with  the  assets  on  the 
debit  side,  as  is  the  American  practice,  or  on  the  credit  side, 
as  is  the  English  practice.  The  balance  of  argument  would 
seem  to  favor  the  latter  on  the  theory  that  a  balance  sheet  is 
intended  to  set  forth  the  position  of  the  owner  of  the  prop- 
erty, who  should  therefore  be  credited  with  what  he  possesses 
and  charged  with  what  he  owes. 

For  the  clear  understanding  and  recording  of  his  affairs, 
the  owner  distributes  himself  into  a  number  of  different 
pockets  and  considers  that  into  each  pocket  he  places  some 
particular  class  of  his  property.  According  to  the  rules  of 
bookkeeping  he  therefore  debits  each  pocket  with  the  value 
placed  upon  the  particular  class,  and  credits  himself  as  the 
one  from  whom  it  is  received.  These  pockets  represent  the 
various  property  and  expense  accounts  in  his  ledger,  and  the 
corresponding  credit  account  is  himself  or,  as  it  is  generally 
styled,  "Capital  Account."  In  the  balance  sheet  prepared 
from  his  books  he  is  summarizing  the  distribution  made  by 
totalling  the  amount  in  each  separate  pocket.  His  balance 
sheet  shows  his  position  in  relation  to  his  books,  and  he  is 
therefore  credited  with  the  items  which  he  has  placed  into 
those  pockets  and  charged  with  those  items  which  he  has 
received  through  other  pockets  from  other  people.  In  other 
words,  the  English  method,  which  seems  more  correct  the- 
oretically, is  "A  in  account  with  his  books,"  while  the  Amer- 
ican method,  which  is  the  reverse,  is  "His  books  in  account 
with  A."  This  brings  out  the  only  really  important  point 
in  this  whole  discussion,  viz. :  that  every  kind  of  account 
stated  must  be  considered  from  the  point  of  view  of  the 
purpose  for  which  it  is  prepared.  If  an  account  is  headed 
"A  in  account  with  B,"  A  should  be  credited  with  what  he 
has  given  to  B ;  while  if  the  account  is  headed  "B  in  account 


THE     BALANCE     SHEET 


37 


with  A,"  it  will  be  reversed.  A  familiar  example  is  often 
found  in  a  banker's  pass  book,  in  which  the  customer's  de- 
posits are  usually  entered  on  the  credit  side  and  his  with- 
drawals on  the  debit ;  while  in  the  depositor's  own  books  the 
record  is  reversed — the  pass  book  is  "A  in  account  with 
the  bank,"  while  the  cash  book  is  "The  bank  in  account 
with  A." 

Apart  from  the  theory  involved  the  matter  has  perhaps 
little  importance  except  as  illustrating  the  modern  tendency 
to  ignore  forms  and  get  at  results  which  after  all  are  the 
most  important.  By  convention  American  balance  sheets 
are  prepared  with  the  assets  on  the  debit,  or  left-hand,  side 
of  the  account,  just  as  by  convention  in  England  they  are 
prepared  in  the  reverse  way.  It  is  also  usual  to  dispense 
with  the  signs  "Dr."  and  "Cr."  on  each  side  of  the  balance 
sheet  and  instead  use  captions  such  as  "Property  and  Assets" 
and  "Capital  and  Liabilities" ;  and  frequently  also  even  the 
fiction  of  sides  disappears,  the  assets  appearing  on  the  upper 
part  of  the  sheet  and  the  liabilities  on  the  lower,  or  the 
reverse. 

In  such  directions  as  these  accounting  diverges  sharply 
from  bookkeeping,  striving  always  to  adopt  such  forms  and 
methods  as  will  result  in  statements  understandable  by  those 
uninitiated  into  the  so-called  "mysteries  of  bookkeeping." 
In  the  strenuous  field  of  modern  business  clearness  is  almost 
as  important  as  accuracy;  for  a  statement  that  is  strictly 
accurate  so  far  as  figures  are  concerned  may  fail  of  being 
understood  by  want  of  care  in  making  it  show  clearly  what 
is  called  for  without  a  further  compiling  or  unraveling  of 
figures.  The  form  of  balance  sheet  already  given  will  be 
found  to  lend  itself  to  a  clear  statement  of  affairs,  as  the 
following  explanatory  remarks  will  show.  It  remains  in 
subsequent  chapters  to  consider  to  what  extent  it  can  achieve 
the  much  more  difficult  ideal  of  accuracy. 


38 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


Analysis  of  Balance  Sheet  Assets 

The  first  essential  in  clearness  is  that  each  caption  should 
express  the  nature  of  the  items  included  therein.  The  six 
main  headings  adopted  are : 

(i)  Fixed  Assets. 

(2)  Permanent  Investments. 

(3)  Investment  of  Reserves. 

(4)  Working  Assets. 

(5)  Current  Assets. 

(6)  Suspense  Debits. 

(i)  Fixed  Assets 

Fixed  assets  include  all  property  which  is  directly  pos- 
sessed and  used  by  the  owner  himself  for  his  enjoyment 
or  for  his  business  purposes,  and  maintained  in  a  fixed  con- 
dition for  long  periods  of  time  subject  only  to  wear  and  tear 
and  depreciation  from  use.  The  figures  in  the  balance  sheet 
should  be  supported  by  detail  schedules  showing  the  amount 
at  the  beginning  of  the  year,  the  additions  during  the  year, 
and  the  deductions  for  depreciation  due  to  use  in  the  busi- 
ness. The  conditions  under  which  account  should  be  taken 
of  other  kinds  of  depreciation  or  of  appreciation  are  dis- 
cussed later. 

(2)  Permanent  Investments 

Under  permanent  investments  is  included  partial  or 
entire  ownership  in  facilities  of  other  persons  or  corporations 
or  similar  bodies  the  ownership  or  control  of  which  is  a 
compulsory  or  necessary  one;  either  because  it  is  a  trust 
ownership  for  special  purposes  extending  over  long  periods 
of  time,  or  because  it  is  so  intimately  connected  with  the 
owner's  activities  that  a  sale  would  diminish  or  otherwise 
interfere  with  the  continuance  of  those  activities.  Under 
this  heading  should  also  appear  advances  made  to  such 
persons  or  corporations  and  employed  by  them,  for  the  time 


THE     BALANCE     SHEET 


39 


being  at  any  rate,  in  carrying  on  their  business.  These  ad- 
vances differ  in  many  respects  from  ordinary  accounts  re- 
ceivable for  goods  sold,  for  they  are  usually  found  upon 
inquiry  to  be  so  much  locked  up  in  fixed  or  working  assets 
as  to  be  not  readily  realizable  and  are  not  in  fact  intended 
to  be  repaid  as  long  as  the  business  for  which  the  advances 
were  made  is  carried  on.  In  practice  these  advances  are 
frequently  and  erroneously  treated  as  accounts  receivable 
under  current  assets,  thereby  often  concealing  a  serious 
shrinkage  in  liquid  assets  which  may  endanger  the  solvency 
of  the  concern. 

(3)  Investment  of  Reserves 

The  caption  "Investment  of  Reserves"  serves  to  show 
what  proportion  of  any  reserves  which  appear  on  the  lia- 
bility side  of  the  balance  sheet  is  specifically  earmarked  and 
invested.  There  should  not  be  included  any  part  of  the  assets 
unless  they  are  specifically  segregated  for  the  service  of  the 
reserves.  Any  difference  between  the  total  of  the  reserves 
and  the  amount  of  these  investments  represents  the  propor- 
tion of  the  reserves  which  is  invested  in  the  general  assets 
and  which  can  only  be  available  by  correspondingly  reducing 
the  latter. 

(4)  Working  Assets 

These  assets  form  another  class  equally  necessary  with 
the  first,  consisting  of  those  assets  which,  while  they 
are  not  intended  for  sale,  are  necessarily  consumed  in  the 
process  of  carrying  on  the  owner's  activities,  whatever  they 
may  be,  and  are  not  directly  represented  anywhere  in  the 
results  of  those  activities.  While  they  are  not  permanent, 
because  they  are  continually  being  consumed,  their  equivalent 
is  permanent  because  they  must  be  continually  renewed  and 
replaced.  Thus  the  activities  of  a  railroad  consist  in  the 
transportation  of  persons  and  commodities  from  place  to 


40 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


place ;  and  in  this  process  coal,  oil,  and  other  supplies  are  con- 
tinually being  consumed,  leaving  no  trace  behind,  and  as 
continually  being  replaced.  In  a  manufacturing  business  the 
same  kind  of  articles  are  being  used  in  the  same  kind  of  way 
in  carrying  out  operations  on  other  materials,  which  latter, 
while  they  change  their  shape  in  the  process,  still  remain  in 
existence,  are  intended  for  sale  and  are  therefore  treated 
as  current  assets.  Balances  in  hands  of  agents  which  do 
not  as  a  rule  exist  wholly  in  the  form  of  cash  and  are  not 
available  for  the  ordinary  purposes  of  a  cash  balance,  are 
perhaps  on  the  border  line  between  working  and  current 
assets,  but  conservative  practice  places  them  in  the  former 
group.  The  third  group  of  items,  representing  payments 
made  in  advance  to  cover  expenses  of  a  subsequent  period, 
and  not  therefore  in  the  ordinary  course  of  business  recover- 
able, are  also  conservatively  treated  as  a  part  of  the  working 
assets.  This  whole  class  is  as  to  the  value,  but  not  as  to  the 
property,  permanent  capital,  subject  only  to  fluctuations 
due  to  conditions  of  trade;  it  differs  from  that  of  fixed  assets 
in  that  both  the  value  and  the  property  included  in  the 
latter  are  of  a  permanent  nature. 

(5)  Current  Assets 

Under  current  assets  are  included,  firstly,  the  property 
which  by  the  aid  of  the  fixed  and  working  assets  is  being 
continuously  converted  from  one  form'into  another,  with  the 
purpose  of  earning  a  profit  by  subsequent  sale  and  con- 
version into  cash;  in  this  respect  differing  markedly  from 
the  two  classes  of  fixed  and  working  assets.  Secondly  are 
included  the  intermediary  instruments,  such  as  bills  and  ac- 
counts receivable,  by  means  of  which  the  conversion  into 
cash  is  made ;  thirdly,  the  equivalent  of  cash  in  the  shape  of 
realizable  and  temporary  investments  held  only  until  an 
outlet  for  the  surplus  cash  is  found  either  in  divisions  of 


THE     BALANCE     SHEET 


41 


profit  or  in  extensions  of  the  business  activities ;  and  fourth- 
ly, the  cash  itself. 

(6)  Suspense  Debits 

The  term  "Suspense  Debits"  is  sufficiently  defined  in 
the  subcaption.  The  items  to  be  included  consist  entirely  of 
those  which  represent  no  value  and  must  sooner  or  later  be 
written  off  entirely  as  losses  or  expenses ;  such  for  instance 
as  debit  balances  on  ventures  or  undertakings  not  yet  com- 
pleted and  not  represented  by  ascertainable  assets ;  discounts 
on  bonds  outstanding,  etc. 

Analysis  of  Balance  Sheet  Liabilities 

Among  the  liabilities  the  first  item  by  convention  is  the 
fixed  capital  invested,  although  in  theory  the  deduction  to 
be  first  made  from  the  total  assets  should  be  the  liabilities  to 
outside  parties,  the  difference  representing  the  net  worth, 
which  is  made  up  partly  of  the  fixed  amount  contributed  as 
permanent  capital  and  partly  of  the  accretions  thereto.  The 
arrangement  adopted  is,  however,  convenient  in  that  where 
the  balance  sheet  is  arranged  on  the  debit  and  credit  prin- 
ciple, the  capital  liabilities  and  unfunded  debt  for  capital 
purposes  appear  opposite  to  the  fixed  and  working  assets  in 
which  they  are  invested,  followed  by  the  current  liabilities 
which  have  to  be  provided  for  by  the  continuous  liquidation 
of  the  current  assets;  the  last  item  being  the  surplus  (or  it 
may  be  deficit,  which  would  be  a  deduction  or  red  figure) 
left  after  providing  for  capital  and  liabilities. 

Capital  Stock 

It  is  desirable  in  the  case  of  a  corporation  that  the  balance 
sheet  should  show  not  only  the  amount  of  capital  which  has 
actually  been  raised  but  also  that  which  is  still  available  if 
required  in  the  future  without  any  change  in  the  charter. 
Such  available  capital  may  be  either ; 


42       ACCOUNTING    PRACTICE    AND    PROCEDURE 

(a)  Capital  authorized  by  the  charter  but  not  yet  created 
by  any  action  of  the  corporation  through  its  stockholders. 

(b)  Capital  authorized  by  the  charter,  created  by  resolu- 
tion of  the  stockholders  but  not  yet  issued  by  any  action  of 
the  directors. 

(c)  Capital  authorized  by  the  charter,  created  by  resolu- 
tion of  the  stockholders,  issued  by  authority  of  the  directors 
but  not  yet  sold  to  any  parties  for  cash  and  consequently  still 
remaining  in  the  treasury  of  the  corporation. 

(d)  Capital  authorized  by  the  charter,  created  by  resolu- 
tion of  the  stockholders,  issued  by  authority  of  the  directors 
and  sold  to  outside  parties ;  but  upon  which  only  a  proportion 
of  the  par  value  has  been  paid,  leaving  the  balance  due  in 
cash  either  immediately  or  when  called  for. 

It  is  a  common  practice  to  treat  stock  issued  but  not  sold 
as  an  asset  and  include  it  among  either  the  fixed  or  current 
assets.  This  practice  is  entirely  incorrect  in  theory  and  also 
inconvenient  in  practice.  In  theory,  treasury  stock  or  bonds 
are  merely  so  many  legalized  pieces  of  paper  entitling  the 
holder  either  to  a  certain  share  in  the  assets  or  to  a  certain 
lien  on  those  assets.  In  neither  case  can  such  pieces  of  paper 
be  in  any  sense  assets  of  the  corporation  creating  and  issuing 
them;  for  the  assets  themselves  already  appear  and  cannot 
be  duplicated  by  resolutions  of  stockholders  or  directors. 
In  practice  difficult  questions  arise  as  to  the  valuation  of 
such  treasury  stock  and  bonds ;  the  value  to  the  corporation 
is  clearly  the  par  value  for  which  the  corporation  itself  is 
liable ;  the  market  value  for  which  they  can  be  sold  may  be 
either  more  or  less,  and  until  they  are  sold,  and  the  proceeds 
become  available  for  the  purposes  of  the  corporation,  it  is 
impossible  to  say  what  their  value  is.  The  real  fact  is  that 
they  have  no  value  in  themselves  and  only  differ  from  similar 
securities  not  yet  authorized  in  that  certain  clerical  formali- 


THE     BALANCE     SHEET 


43 


ties  have  been  completed  which  render  them  more  available 
either  for  sale  when  further  capital  is  required  or  for  pledg- 
ing as  security  for  loans.  This  latter  fact  is  certainly  one 
that  should  be  made  apparent  in  connection  with  the  balance 
sheet,  and  this  can  be  done  correctly  and  without  infringing 
any  sound  principles  of  finance  by  attaching  to  the  balance 
sheet  an  exhibit  in  the  following  form  : 


•V 

Amount  in 

3 

c 
o 

•o 

•o 

Treasury 

in 

1) 

<u 

t—i  ,, 

O.-^'O 

N 

o 

3   O 

3ii 

■hi 

-M.a 

l-  o  O 

§1 

g-« 

0  4= 
S3 

O  ei 

§  = 

E  « 

Pledged 

Unpledged 

B^ 

Qoo 

m< 

« 

<U 

^  "" 
<;i— I 

<2 

Funded  and  Unfunded  Debt 

A  distinction  is  made  between  permanent  or  long  term 
loans  or  Funded  Debt  which,  subject  to  their  conditions  and 
amount,  are  a  source  of  strength  as  representing  permanent 
capital,  and  other  loans  raised  for  capital  purposes  and  pay- 
able on  demand  or  at  short  dates,  which  are  frequently 
termed  "Unfunded  Debt."  For  the  former,  except  in  case  of 
default,  no  immediate  provision  requires  to  be  made  other 
than  for  the  sinking  fund  payments  providing  for  gradual 
redemption  for  which  alone  the  current  assets  are  obligated. 
The  latter,  on  the  other  hand,  are  a  source  of  weakness, 
evidencing  the  necessity  of  an  increase  in  the  permanent 
capital  and  in  the  meantime  constituting  a  direct  obligation 
against  the  current  assets  which  might  at  any  time  lead  to 
difficulties  if  not  to  disaster. 


44 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


Current  Liabilities 

Under  current  liabilities  appear,  firstly,  those  to  bankers 
and  others  for  temporary  loans  raised  for  current  purposes, 
such  as  to  provide  for  seasonal  or  temporary  expansion  of 
business,  which  will  be  automatically  retired  as  business 
again  returns  to  the  minimum  or  normal  condition.  The  dis- 
tinction between  such  loans  and  unfunded  debt  may  easily 
be  a  fine  one;  for  any  permanent  increase  in  current  assets 
due  to  progressive  growth  of  the  business  should  undoubted- 
ly be  provided  for,  not  by  such  temporary  loans,  but  by  an 
addition  to  the  permanent  capital.  There  is,  however,  a 
fairly  clear  line  of  demarcation  between  loans  raised  to  meet 
additions  to  fixed  capital  and  those  raised  for  temporary  ad- 
ditions to  current  or  circulating  capital,  and  it  is  this  dis- 
tinction for  which  the  classification  adopted  is  intended  to 
provide.  Ordinary  liabilities  on  bills  and  accounts  payable 
call  for  no  explanation,  but  it  should  be  noted  that  provision 
is  made  under  the  caption  of  current  liabilities  for  losses 
actually  incurred  but  not  definitely  ascertained,  and  for  con- 
tingencies that  may  arise  out  of  past  and  completed  trans- 
actions, such  as  claims  for  defects  when  a  term  guarantee  is 
given.  Such  items  are  direct  liabilities  which  must  be  met 
in  a  short  time  out  of  current  assets,  as  distinct  from  the 
provision  made  for  contingencies  at  present  unknown  and 
unforeseen  which  may  arise  out  of  future  operations.  The 
latter  are  clearly  a  mere  allocation  of  surplus  made  for 
reasons  of  prudence. 

Depreciation 

There  is  another  class  of  provisions  intermediate  between 
these  two,  viz. :  those  for  depreciation,  or  wear  and  tear,  of 
fixed  capital  arising  out  of  its  use  in  the  activities  of  the 
business;  and  for  exhaustion  of  minerals  and  other  subsoil 


THE    BALANCE    SHEET 


45 


products  due  to  their  actual  removal  from  the  land  with  a 
consequent  reduction  in  the  property  represented  in  the 
fixed  assets.  If  these  provisions  are  included  on  the  liability- 
side  of  the  balance  sheet  they  will  require  a  separate  main 
heading,  such  as  "Provisions  for  Depreciation,"  which  should 
find  its  place  between  current  liabilities  and  surplus.  They 
are  not  a  part  of  the  surplus  because  they  represent  an  esti- 
mate of  losses  actually  incurred,  nor  are  they  current  liabili- 
ties because  they  do  not  necessarily  become  a  charge  upon 
current  assets ;  or,  if  they  do,  they  act  as  a  replacement  of 
wasted  property,  i.  e.,  a  transfer  from  current  to  fixed  assets. 
Both  in  theory  and  practice  such  provisions  should  prefer- 
ably be  deducted  from  the  fixed  assets  to  which  they  relate, 
and  the  pro  forma  balance  sheet  here  submitted  is  so  drawn 
up.  The  argument  for  including  provision  for  depreciation 
and  exhaustion  on  the  liability  side  of  the  balance  sheet  is 
largely  one  of  expediency,  in  that  in  practice  it  has  been 
found  easier  to  bring  home  the  importance  of  adequate 
provision  when  the  amount  so  set  aside  from  year  to  year  is 
kept  in  evidence;  and  also  because  the  amount  is  necessarily 
an  estimate  only  and  at  some  time  in  the  future  involves  the 
actual  expenditure  of  at  any  rate  a  large  part  of  the  ac- 
cumulated provision. 

Suspense  Credits 

Under  Suspense  Credits  should  be  grouped  items  which 
in  all  probability  will  ultimately  form  credits  to  Income  or 
Surplus ;  such  for  instance  as  credit  balances  on  ventures  or 
undertakings  not  yet  completed;  premiums  on  outstanding 
bonded  debt,  etc. ;  but  not  including  payments  received  in 
advance  of  due  dates  which,  until  such  dates  arrive  and  the 
service  for  which  they  are  received  is  performed,  are  a  direct 
liability. 


46      ACCOUNTING    PRACTICE    AND    PROCEDURE 

Surplus 

Under  the  head  "Surplus"  should  be  included  all  those 
provisions  which  may  be  styled  voluntary,  although  in  prac- 
tice this  course  is  seldom  followed.  There  can  be  no  doubt 
that  all  such  are  in  effect  allocations  of  surplus,  specially  ear- 
marked, for  purposes  which  may  never  arise;  and  that 
merely  to  give  different  names  to  such  allocations  does  not 
alter  the  facts.  On  the  other  hand,  some  of  the  contingencies 
provided  against  will,  according  to  the  law  of  averages, 
arise  at  some  time ;  and  inasmuch  as  accidents  and  such  like 
contingencies,  which  only  occur  at  considerable  intervals  of 
time,  should  perhaps  be  treated,  as  accruing  year  by  year, 
there  is  reason  for  building  up  a  fund  to  meet  them  when 
they  do  arise,  by  annual  contributions  from  surplus.  It  is 
submitted,  however,  that  until  the  contingency  does  arise 
the  sum  provided  is  part  of  the  surplus ;  and  its  probability 
is  sufficiently  and  more  accurately  recognized  by  such  an 
allocation  as  that  suggested  than  by  the  more  usual  method 
of  creating  a  separate  group  heading  of  "Provisions  and 
Reserves"  between  current  liabilities  and  surplus.  This  is 
particularly  true  of  sinking  fund  appropriations  which  are 
usually  mere  accumulations  of  surplus  to  take  the  place  in 
the  permanent  capital  of  bonded  indebtedness  retired.  Un- 
less these  sinking  fund  provisions  have  been  applied  in  lieu 
of  depreciation  or  exhaustion,  in  which  case  they  should  be 
deducted  from  the  asset  account,  they  differ  in  no  way  from 
undistributed  profits,  which  are  also  largely  employed  to  pro- 
vide permanent  capital  for  the  extension  of  business. 

Appropriated  Surplus 

"Other  Appropriations  for  Capital  Purposes"  would  rep- 
resent amounts  specifically  set  aside  out  of  profits  for  ad- 
ditions to  and  extensions  of  the  fixed  or  working  assets.  A 
similar  caption  is  found  in  the  balance  sheet  prescribed  by  the 


THE    BALANCE    SHEET 


47 


Interstate  Commerce  Commission  for  the  use  of  transporta- 
tion companies  under  the  heading  of  "Appropriated  Sur- 
plus," representing  the  appropriations  made  by  such  com- 
panies out  of  surplus  earnings  for  capital  purposes,  which 
under  former  methods  disappeared  from  the  accounts  alto- 
gether, being  directly  charged  against  the  annual  profits. 

The  allocation  of  profits  for  capital  expenditures  should 
be  considered  a  temporary  appropriation  thereof  only,  as  by 
raising  further  fixed  capital  to  provide  for  these  expenditures 
the  profits  so  set  aside  become  again  available  for  distribu- 
tion. The  allocation  may  at  any  time  be  made  permanent 
by  converting  it  into  capital  stock  by  means  of  a  stock- 
dividend. 


Profit  and  Loss 

The  item  ''Undistributed  Balance  of  Profits  (or  Losses)" 
may  be  a  debit  instead  of  a  credit  if  more  than  the  profits 
earned  have  been  distributed  or  there  have  been  losses  instead 
of  profits;  and  technical  bookkeeping  would  then  require 
that  this  figure  be  placed  on  the  asset  instead  of  the  liability 
side  of  the  balance  sheet.  Where  the  other  captions  of  the 
surplus  account  are  together  in  excess  of  the  debit  on  "Un- 
distributed Balance  of  Profits  (or  Losses),"  it  will  conduce 
to  a  clearer  understanding  of  the  true  position  if  the  latter 
item  is  retained  in  the  same  position  and  is  especially  noted 
as  a  debit,  which  in  practice  is  done  by  entering  the  figures 
either  (if  typed  or  written)  in  red  ink  signifying  a  de- 
duction, or  (if  printed)  in  italics,  frequently  with  a  star 
referring  to  a  footnote  reading  "Deficit" ;  or  by  inserting 
the  word  "deduct"  and  changing  the  caption  so  as  to  read 
"Deduct — Deficit  on  Profit  and  Loss  Account."  By  thus 
adhering  to  the  form,  whether  there  are  profits  or  losses, 
uniformity  is  secured  and  the  comparison  of  conditions  and 


48      ACCOUNTING    PRACTICE    AND    PROCEDURE 

results  is  made  easier,  particularly  to  those  who  have  to  study 
the  figures  without  any  special  bookkeeping  knowledge. 

English  Requirements  as  to  Balance  Sheet 

It  will  be  useful  to  refer  here  to  the  requirements  as  to 
balance  sheets  in  England  contained  in  Section  26  of  the 
Companies  (Consolidation)  Act  1908,  which  provides  that 
every  company  must  furnish  once  in  each  year  and  forward 
to  the  Registrar  of  Joint  Stock  Companies  a  summary  of  its 
affairs,  including  "a  statement,  made  up  to  such  date  as  may 
be  specified  in  the  statement,  in  the  form  of  a  balance  sheet, 
audited  by  the  company's  auditors,  and  containing  a  sum- 
mary of  its  capital,  its  liabilities,  and  its  assets,  giving  such 
particulars  as  will  disclose  the  general  nature  of  those  liabili- 
ties and  assets,  and  how  the  values  of  the  fixed  assets  have 
been  arrived  at,  but  the  balance  sheet  need  not  include  a 
statement  of  profit  and  loss." 

Balance  Sheet  Forms 

In  the  form  of  balance  sheet  most  commonly  adopted  in 
England,  each  class  of  asset  is  separately  extended  in  the 
balance  sheet  in  an  order  corresponding  to  the  ease  of  liqui- 
dation— that  is  to  say,  the  more  fixed  assets  are  stated  first, 
followed  by  those  which  are  slightly  more  realizable,  and 
ending  with  the  most  realizable  of  all,  viz. :  cash,  but  with  no 
group  classifications  into  fixed,  working  and  current  assets. 

The  difference  between  the  two  forms,  both  of  which 
may  with  equal  accuracy  and  clearness  set  forth  the  true 
financial  position,  makes  it  necessary  to  state  that  while 
the  form  given  in  this  chapter  may  be  ideal  for  a  balance 
sheet,  it  does  not  follow  that  it  is  the  only  correct  form 
and  that  an  accountant  in  the  exercise  of  his  public  duties 
ought  not  to  certify  to  any  other.  The  proprietors  or  direc- 
tors who  submit  the  accounts  to  their  associates  or  stock- 


THE     BALANCE    SHEET 


49 


holders  have  the  right  to  decide  upon  the  form  in  which 
those  accounts  shall  be  submitted,  and  to  require  the  ac- 
countant to  certify  to  them  in  that  form,  or  to  state  in  what 
respect  he  finds  them  incorrect  or  misleading.  The  latter 
will  have  his  own  ideas  as  to  the  best  method  of  stating  the 
accounts,  and  is  fully  entitled  to  put  his  views  before  his 
clients  and  endeavor,  in  so  far  as  he  can,  to  mould  their 
ideas  to  his,  but  he  must  remember  that  the  object  of  the 
accounts  is  to  set  forth  the  "true  financial  condition"  and 
that  there  is  no  stereotyped  way  in  which  this  should  be 
done.  There  is  a  good  deal  to  be  said  for  uniformity  in  the 
matter  of  form  of  statements  of  similar  concerns,  but  this  is 
a  matter  of  convenience  more  than  of  necessity,  and  no  pre- 
conceived ideas  as  to  the  superiority  of  one  form  over  an- 
other should  be  allowed  to  interfere  with  the  rights  of  the 
proprietors  or  directors  to  state  the  accounts  in  any  form 
they  please  and  to  call  upon  the  accountant  to  certify  them  in 
such  manner  as  he  may  think  fit. 

If  a  balance  sheet  is  to  be  of  any  use  to  those  into  whose 
hands  it  may  come,  it  is  a  first  essential  that  in  whatever 
form  it  may  be  drawn  up,  the  different  captions  should 
clearly  show  what  class  of  items  they  cover  and  should  not 
be  used  to  conceal  items  of  an  entirely  different  nature. 

Misleading  Statements  in  Balance  Sheets 

The  following  instances  of  misleading  descriptions  which 
are  not  unknown  in  practice  will  show  clearly  the  danger 
involved  to  those  who  may  rely  on  the  balance  sheet  as  a 
guide  to  the  financial  position. 

Land,  buildings,  plant  and  machinery  may  be  stated  in 
one  item  without  any  reference  to  such  items  as  franchises, 
patents,  and  goodwill,  which  may  make  up  more  than  half 
the  total.  This  would  convey  to  a  reader  of  the  balance 
sheet  that  the  concern  owned  a  much  more  valuable  plant 


50 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


than  was  actually  the  case;  and  while  the  inclusion  in  the 
caption  of  the  terms  omitted  would  not  give  him  any  very 
definite  information  it  would  lead  to  inquiry  and  so  to  a 
truer  appreciation  of  the  facts. 

An  item  of  cash  and  cash  assets  may  be  given  which 
really  includes  (i)  investments  not  readily  saleable;  (2) 
accounts  and  bills  receivable  many  of  which  are  irrecover- 
able; (3)  material  and  supplies.  This  is  an  entire  mis- 
description of  important  items  and  gives  no  idea  whatever 
of  the  true  position.  In  fact,  this  caption  itself  while  oc- 
casionally used  is  so  vague  as  to  be  without  any  value  and 
it  should  never  be  employed. 

Accounts  receivable  may  be  entered  at  their  face  value, 
while  the  reserves  made  for  bad  and  doubtful  accounts  may 
be  included  in  miscellaneous  provisions  made  out  of  surplus. 
In  this  way  the  value  of  the  asset  is  overstated  and  the 
facts  concealed. 

Investments  or  accounts  receivable  under  the  group  of 
current  assets  may  include  investments  in  or  advances  to 
concerns  which  are  vital  to  the  continuance  of  the  business 
and  for  that  reason  cannot  be  realized.  In  this  way  the 
current  assets  available  to  meet  current  liabilities  may  be 
seriously  overstated. 

Many  other  instances  might  be  given  but  the  above  are 
sufficient  to  show  the  importance  of  an  accurate  classification 
and  description,  and  the  fuller  discussion  of  the  principles 
governing  the  correct  valuation  of  different  classes  of  assets 
and  liabilities  will  throw  further  light  on  this  subject. 

Condensed  Financial  Statement 

The  following  condensed  form  of  statement  is  frequently 
employed  and  has  the  advantage  of  clearly  showing  the 
relation  of  property  assets  and  liabilities  to  capital  and 
surplus : 


THE     BALANCE    SHEET  rj 

Fixed  Property: 

Land  and  Buildings $ 

Plant  and  Machinery,  Tools  and  Fix- 
tures  

Patterns,   Drawings  and   Dies 

Patents,  Goodwill  and  Franchises 


Permanent  Investments 

Working   Assets 

Current  Assets: 

Materials  and  Products  of  Manufac- 
ture      $ 

Accounts  and  Bills  Receivable 

Investments    

Cash    


Less — Current    Liabilities. 

Net  Assets., 


$ 


Represented  by 

Share  Capital 

Loan    Capital 

Surplus   $ 

Suspense  Balance . . 


Such  a  form  which  can  be  incorporated  in  a  general  re- 
port with  comments  on  each  item  is  frequently  of  use  in 
bringing  the  facts  clearly  before  those  who  have  no  familiar 
knowledge  of  the  technicalities  of  bookkeeping. 

Statutory  Forms  of  Balance  Sheet 

Reference  may  here  be  made  to  the  statutory  forms  of 
balance  sheet  prescribed  for  transportation  companies  and 
to  that  proposed  tentatively  by  the  Federal  Reserve  Board 
for  merchants  and  manufacturers. 

Transportation  companies  in  the  United  States  are  re- 
quired by  the  Interstate  Commerce  Commission  to  file  bal- 
ance sheets  in  certain  forms,  and  that  relating  to  steam  rail- 
roads is  given  in  Appendix  VI.  The  Interstate  Commerce 
Commission  issues  pamphlets  giving  full  details  of  the  man- 
ner in  which  items  should  be  grouped,  and  requires  that  the 


52 


ACCOUNTING  PRACTICE  AND   PROCEDURE 


companies  shall  keep  their  accounts  in  accordance  with 
the  classifications  prescribed.  The  same  forms  have  been 
adopted  by  many  companies  for  reports  to  their  stock- 
holders. 

The  balance  sheet  form  for  steam  railroads  went  into 
effect  on  July  i,  19 14,  and  represents  a  revision  of  an  earlier 
form.  The  revision  was  made  with  the  co-operation  of  the 
Association  of  American  Railway  Accounting  officers,  and 
its  Standing  Committee  on  Corporate  Fiscal  and  General 
Accounts,  and  was  presented  in  tentative  form  to  the  chief 
accounting  officer  of  each  railway  and  to  the  railway  com- 
missions of  the  several  states  for  criticism  and  suggestion 
before  being  finally  adopted  and  prescribed.  The  revision 
has  put  right  several  defects  in  the  earlier  form.  Securities 
of  the  company's  own  issue  owned  by  the  company  ap- 
peared on  the  earlier  form  as  assets,  under  the  head  of 
"Securities,"  as  well  as  on  the  liability  side  of  the  balance 
sheet  under  the  head  of  "Stock"  and  "Mortgage,  Bonded 
and  Secured  Debt,"  thus  in  effect  duplicating  to  that  extent 
the  property  of  the  company.  They  are  shown  properly  in 
the  present  form  as  deductions  from  the  gross  liabilities  of 
which  they  form  part,  so  that  the  total  liabilities  include 
only  the  net  amounts  actually  outstanding.  The  objection- 
able captions  "Working  Assets"  and  "Working  Liabilities" 
have  been  dropped.  The  caption  "Current  Assets"  in  the 
revised  form,  is  intended  to  comprise  "only  items  of  avail- 
able assets  or  of  assets  which  there  is  a  reasonable  assurance 
will  become  available  within  a  year  from  the  date  of  the  bal- 
ance sheet."  Temporary  advances  to  proprietary  companies, 
which  in  the  earlier  form  were  included  under  "Deferred 
Debit  Items,"  are  in  the  present  form  classified  as  "Invest- 
ments," or,  if  subject  to  current  settlement,  as  Current 
Assets.  "Cash  and  Securities  in  Sinking  Funds,"  formerly 
included  among  the  "Deferred  Debit  Items,"  are  now  shown 


THE  BALANCE   SHEET 


53 


as  "Sinking  Fund"  under  "Investments,"  and  securities  of 
the  company's  own  issue  held  in  them  are  deducted  on  the 
face  of  the  balance  sheet  from  the  total  assets  in  the  sinking 
funds  and  from  the  liabilities  of  which  the  issues  form  a  part. 

The  revised  form  provides  a  very  full  statement  of  the 
assets  and  liabilities  of  the  company,  but  is  not  yet  free  from 
defects.  The  provision  for  items  arising  out  of  railroad 
leases  and  certain  types  of  equipment  trust  agreements  are 
inadequate;  accrued  depreciation  of  leased  equipment  is 
mentioned  in  the  pamphlet  instructions  as  forming  part  of 
the  item  "Other  Unadjusted  Credits,"  but  neither  accrued 
amortization  of  the  investment  in  property  to  be  surrendered 
at  the  termination  of  a  lease,  nor  non-interest  bearing  obli- 
gations to  lessor  companies  which  will  be  liquidated  then, 
are  specifically  provided  for,  though  such  items  are  often 
of  considerable  amount.  The  groups  "Unadjusted  Debits" 
and  "Unadjusted  Credits"  include  both  items  which  are 
expected  to  become  current  or  investment  assets  or  current 
liabilities,  but  whose  precise  amount  has  not  been  deter- 
mined, and  items  which  are  deferred  charges  or  credits  to 
Income  or  Profit  and  Loss  account.  The  items  "Other  Un- 
adjusted Debits"  and  "Other  Unadjusted  Credits"  provide 
places  for  concealing  accounts  without  any  proper  classifi- 
cation of  their  nature;  an  inspection  of  railroad  balance 
sheets  shows  that  full  advantage  is  taken  of  these  captions, 
the  items  placed  under  them  amounting  frequently  to  very 
large  sums. 

The  balance  sheet  form  for  electric  railways  now  in 
force  also  went  into  effect  on  July  i,  19 14,  and  is  substan- 
tially the  same  as  that  for  steam  railroads.  The  item  "Im- 
provements on  Leased  Railway  Property"  is,  ho\vever, 
omitted,  and  the  items  "Accrued  Depreciation — Road"  and 
"Accrued  Depreciation — Equipment"  are  consolidated  into 
a  single  item. 


54  ACCOUNTING  PRACTICE  AND   PROCEDURE 

The  balance  sheet  form  for  steamship  companies  be- 
came effective  January  i,  19 13,  and  is  on  lines  similar  to 
those  of  the  earlier  form  for  steam  railroads  to  which  ref- 
erence has  been  made.  The  captions  of  "Working  Assets" 
and  "Working  Liabilities"  are  maintained,  but  securities  of 
the  company's  own  issue  owned  by  the  company  are  prop- 
erly shown  as  deductions  from  the  liabilities. 

A  tentative  form  of  balance  sheet  proposed  by  the  Fed- 
eral Reserve  Board  for  merchants  and  manufacturers  in 
the  United  States  is  given  in  Appendix  VII.  It  was  re- 
printed from  the  April,  19 17,  number  of  the  Federal  Re- 
serve Bulletin,  and  was  widely  circulated  among  bankers, 
merchants,  manufacturers,  and  accountants  with  a  view  to 
encouraging  criticism  and  discussion.  It  was  presented  in 
connection  with  a  clear  and  full  set  of  instructions  covering 
the  performance  of  balance  sheet  audits,  and  suggesting 
the  form  of  auditor's  certificate  that  should  accompany  the 
balance  sheet. 

Forms  are  prescribed  for  National  Banks  and  by  the 
different  states  for  transportation  and  other  public  utility 
companies,  for  life  assurance  companies,  etc. 

Statutory  forms  have  resulted  in  uniformity  of  state- 
ments in  place  of  the  diversity  and  chaos  which  previously 
existed.  It  is  now  easy  to  compare  two  companies,  and 
there  is  no  doubt  that  the  possibility  of  such  comparisons, 
even  upon  a  basis  that  is  defective  in  form,  must  go  a  long 
way  to  compensate  for  any  defects  that  may  exist. 


CHAPTER  III 

THE  PROFIT  AND  LOSS  ACCOUNT 

AND  THE  GENERAL  PRINCIPLES   GOVERNING 

ITS  PREPARATION 

Loss  and  Gain  Terminology 

The  item  of  "Undistributed  Balance  of  Profits  (or 
Losses)"  in  the  balance  sheet  discussed  in  Chapter  II 
will  be  supported  by  an  account,  made  up  from  the  books, 
to  which  various  names  are  given  in  practice.  The  variety 
of  terms  used  has  resulted  in  the  absence  of  any  clear  under- 
standing as  to  the  use  or  meaning  of  "Manufacturing  Ac- 
count," "Trading  Account,"  "Profit  and  Loss  Account," 
"Revenue  Account,"  "Gross  Revenue  Account,"  "Net  Rev- 
enue Account,"  "Income  Account,"  "Gross  Income  Ac- 
count," "Net  Income  Account,"  and  there  is  urgent  need 
for  an  agreement  upon  a  proper  terminology  in  this  as  in 
so  many  other  matters  relating  to  accounts.  It  is  proposed 
here  to  attempt  to  introduce  some  order  into  this  confusion 
by  suggesting  a  use  of  the  terms  upon  which  agreement 
might  be  obtained. 

Varying  Purposes  of  Financial  Statements 

It  should  first  be  noted  that  just  as  the  values  of  assets 
and  liabilities  set  forth  in  a  balance  sheet  are  estimates  of 
value  only,  so  too  the  balance  of  undistributed  profits  and 

55 


56 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


losses  is  an  estimate  revised  up  to  date.  It  therefore  is  a 
cumulative  account  and  must  include  all  items  of  profit  and 
loss  which  have  not  been  brought  into  account  previously, 
whether  such  items  accrued  in  the  period  under  immediate 
review  or  in  a  previous  period.  In  this  connection  a  dis- 
tinction must  be  drawn  between  a  statement  of  profits  and 
losses  made  up  annually  or  at  some  regular  interval  for  the 
purpose  of  showing  as  nearly  as  possible  the  results  for 
each  consecutive  period  shortly  after  the  close  of  that  period ; 
and  a  comparative  statement  of  profits  for  a  series  of  such 
periods,  made  up  for  the  purpose  of  determining  as  accurate- 
ly as  possible  the  earning  capacity  of  the  business.  In  the 
latter  case  the  review  is  made  at  a  longer  interval  after  the 
occurrence  of  the  transactions  and  a  more  accurate  state- 
ment is  thus  possible.  Moreover,  as  the  object  of  such  a 
comparative  statement  is  to  reflect  as  nearly  as  possible  the 
true  conditions  of  the  business,  many  adjustments  and  re- 
serves made  in  annual  accounts  for  the  purpose  of  safety 
will  not  be  required  and  in  fact  will  often  be  incorrect  when 
a  measure  of  earning  capacity  is  required.  On  the  other 
hand,  overlapping  items  belonging  to  previous  periods, 
which  in  preparing  statements  of  earning  capacity  would  be 
relegated  to  the  periods  to  which  they  belong,  should  not  be 
excluded  from  an  annual  statement  of  profits  and  losses,  for 
the  reason  that  the  latter  is  merely  a  revision  up  to  date  of 
all  profits  and  losses  incurred  as  far  as  the  same  are  ascer- 
tainable. In  other  words,  a  statement  of  earning  capacity 
necessarily  and  properly  involves  more  facts  and  less  esti- 
mates than  a  recurrent  annual  statement  of  profits  and  losses. 

Classification  of  Activities 

The  account  which  analyzes  the  manner  in  which  gains 
or  losses  have  occurred  may  be  divided  into  separate  portions 
corresponding  to  distinct  stages  in  the  process  of  arriving  at 


THE    PROFIT    AND    LOSS    ACCOUNT  57 

the  final  balance.    For  the  purpose  of  defining  these  stages, 
activities  may  be  grouped  into  the  following  classes : 

(i)  Manufacturing. 

(2)  Merchandising. 

(3)  Agency  and  Commission. 

(4)  Transportation. 

(5)  Banking. 

(6)  Professional. 

(7)  Private. 

(i)  Manufacturing 

In  a  manufacturing  business  the  activities  consist  in 
converting  materials  by  means  of  labor  and  the  use  of  fixed 
and  working  assets  into  a  shape  in  which  they  are  saleable. 
The  sale  price  forms  the  gross  earnings  from  sales  and, 
after  deductions  of  returns,  allowances  and  discounts,  gives 
the  net  earnings.  The  difference  between  the  net  earnings 
from  sales  and  the  cost  of  conversion  is  the  gross  profit 
derived  from  the  activity ;  but  in  order  to  realize  this  gross 
profit,  i.e. J  to  convert  it  into  net  profit,  expenses  must  be 
incurred  for  selling  the  products  and  for  general  supervision. 
Deducting  these  expenses  the  net  profit  for  the  period  is 
obtained  which  is  applicable  to  provide  for  general  reserves 
and  for  remuneration  of  the  capital  employed.  Any  sur- 
plus remaining  after  making  these  deductions  would  be 
added  to  the  surplus  of  previous  periods  and  be  available  to 
make  good  extraordinary  losses  not  due  to  the  activities 
carried  on;  or  to  extend  the  business;  or  for  such  other 
voluntary  purposes  as  may  be  determined;  and  this  final 
amount  would  also  be  subject  to  increase  by  accretions  to 
property  or  assets  arising  from  causes  not  connected  with 


^8      ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  activities.    Hence,  we  have  the  following  main  divisions 
of  account : 

(i)  Manufacturing  account  (a  term  already  in  general 
use),  to  the  credit  of  which  would  be  placed  the  gross  earn- 
ings from  sales,  which  by  deduction  of  allowances  and  trade 
discounts  would  show  net  earnings  from  sales ;  on  the  debit 
side  would  be  shown  the  cost  of  manufacture  up  to  the  point 
where  the  products,  would  be  ready  for  sale ;  and  the  balance 
would  be  the  gross  profit  from  manufacture. 

(2)  Income  account,  which  will  take  up  the  expenses 
of  sale  and  supervision  necessary  to  convert  this  gross  profit 
into  available  or  net  profit. 

(3)  Net  Income  account,  showing  the  disposition  made 
of  net  profit  and  the  surplus  profit  remaining,  leading  up  to — 

(4)  Profit  and  Loss  account  (frequently  styled  "Sur- 
plus"), which  is  a  cumulative  account  of  all  profits  and 
losses  whether  arising  from  the  activities  dealt  with  in  the 
earlier  accounts  or  otherwise,  the  balance  of  which  will  form 
the  item  of  undistributed  profits  and  losses  in  the  balance 
sheet. 

Dividends  on  stocks  may  be  charged  either  to  Net  In- 
come account  if  it  is  desired  that  they  be  paid  only  out  of 
the  results  of  the  period,  or  to  Profit  and  Loss  account  if,  as 
is  generally  proper,  they  are  to  be  paid  out  of  cumulative 
results. 

(2)  Merchandising 

In  a  merchandising  business  the  processes  and  accounts 
would  be  the  same,  except  that  in  place  of  conversion  the 
first  operation  is  to  buy  and  collect  in  bulk,  divide  into  small 
packages  and  store  in  shape  convenient  for  sale.  The  various 
costs  entering  into  this  operation  are  different  in  nature 
from,  and  very  much  simpler  than,  those  which  enter  into  the 


THE    PROFIT    AND    LOSS    ACCOUNT  59 

Operation  of  manufacture,  and  the  term  "Trading  Account" 
already  in  general  use  for  the  purpose  may  well  be  con- 
tinued as  the  title  of  the  first  division  in  place  of  "Manufac- 
turing Account."  The  other  three  accounts  would  remain 
the  same. 

(3)  Agency  and  Commission 

In  an  agency  or  commission  business  no  merchandise  or 
property  of  any  kind  is  dealt  in  for  the  account  of  the  owner 
of  the  business,  but  is  merely  handled  for  the  account  of  the 
seller  or  purchaser,  the  owner  of  the  business  being  remuner- 
ated by  a  commission  which  forms  his  gross  profit,  from 
which  are  deductible  the  expenses  of  supervision,  losses  on 
guarantees,  etc.,  the  balance  being  the  net  profit  from  his 
agency  business.  If,  as  is  frequently  the  case,  he  takes  shares 
in  ventures  with  his  customers  he  is  in  effect  carrying  on  also 
a  different  business,  coming  under  one  of  the  other  cate- 
gories enumerated  and  subject  to  the  same  considerations. 
His  accounts  as  an  agency  and  commission  merchant  will 
thus  consist  only  of  the  Income  account,  Net  Income  account 
and  Profit  and  Loss  account. 

(4)  Transportation 

In  a  transportation  business  conditions  are  materially 
different.  There  is  no  manufacturing  or  merchandising 
involved  in  the  main  business  of  transportation,  although 
such  frequently  exists  as  a  side  issue,  and  the  results  of 
these  would  be  brought  from  their  respective  Manufacturing, 
Trading  and  Income  accounts  into  the  Net  Income  account. 
The  main  activity  is  the  transportation  of  passengers,  mer- 
chandise, etc.,  at  fixed  rates  and  the  revenue  from  this  source 
forms  the  gross  earnings  and  after  deduction  of  any  allow- 
ances results  in  the  net  earnings.  Before  these  net  earnings 
are  available,  just  as  in  the  case  of  net  earnings  from  sales. 


6o      ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  service  of  transportation  must  be  performed,  and  the 
balance  remaining  after  performing  this  service  is  the  gross 
profit.  To  follow  out  the  analogy  of  manufacturing  and 
jobbing  activities  there  should  be  charged  against  this  gross 
profit  the  expense  of  obtaining  customers  and  of  general 
supervision.  Accounts  of  transportation  companies  are, 
however,  governed  by  the  rules  of  the  Interstate  Commerce 
Commission  and  of  the  various  Public  Service  Commissions, 
which  have  ignored  this  distinction;  and  all  these  expenses 
are  merged  with  the  cost  of  transportation  into  one  general 
term  "operating  expenses"  so  that  the  true  "gross  profit" 
is  lost  and  the  first  balance  reached  is  net  profit.  Hence,  the 
main  divisions  of  account  are  reduced  to  these,  viz. : 

(i)  Income  account,  generally  known  as  Operating 
account,  which  is  credited  with  net  earnings  from  operation 
and  charged  with  operating  expenses  and  taxes,  resulting  in 
the  net  profit  or  operating  income. 

(2)  Net  Income  account,  generally  known  as  Income 
account. 

(3)  Profit  and  Loss  account. 

The  use  of  the  two  last  accounts  is  identical  with  that 
stated  for  manufacturing  activities. 

(5)  Banking 

In  banking  accounts  net  earnings  are  gross  profit  as  there 
are  usually  no  deductions  representing  cost  of  the  specific 
service  performed.  In  the  case,  however,  of  the  activity 
generally  known  as  "Promotion,"  the  net  earnings  will 
generally  be  subject  to  many  direct  charges  for  purchases, 
expenses,  etc.,  relating  to  the  particular  promotion,  and  an 
account  similar  to  a  trading  account  will  be  required;  this 
term,  with  a  prefix  to  indicate  the  particular  promotion  or 
other  activity  concerned,  might  well  be  retained. 


THE    PROFIT    AND    LOSS    ACCOUNT  6l 

The  principal  credits  in  the  income  account  will  be  the 
gross  profit  from  these  separate  trading  accounts  as  well 
as  interest  received,  brokerage  on  sales  and  purchases  of 
securities  for  customers,  etc.,  all  of  which  latter  are  net 
earnings  and  income ;  and  on  the  debit  side  interest  paid  to 
customers,  general  business  expenses,  etc.,  the  balance  being 
the  net  profit  as  before.  It  should  be  noted  that,  as  bankers 
are  dealers  in  money,  interest  paid  to  or  received  from 
customers  in  the  ordinary  course  of  business,  which  in  other 
cases  is  a  division  of  profit,  becomes  an  expense;  but  this 
does  not  apply  to  interest  paid  to  parties  who  share  directly 
or  indirectly  in  the  business  activities  carried  on,  which 
would  still  be  a  division  of  profit  and  as  such  chargeable  to 
Net  Income  account.  In  this  case,  therefore,  there  are  also 
four  accounts : 

(i)  Trading  account  (for  each  separate  promotion  or 
similar  activity) 

(2)  Income  account 

(3)  Net  Income  account 

(4)  Profit  and  Loss  account 

Where,  as  in  a  private  firm,  the  entire  profits  are  regu- 
larly divided  at  the  end  of  each  period  there  will  be  no  profit 
and  loss  account. 

(6)  Professional  Activities 

In  professional  activities  such  as  those  of  lawyers, 
accountants,  engineers,  doctors,  etc.,  the  net  earnings,  i.  e., 
gross  fees  received  less  any  out-of-pocket  expenses  incurred 
on  any  particular  case  and  included  in  the  bill  rendered,  are 
subject  to  deduction  of  the  cost  of  the  service  rendered  in 
each  case,  the  balance  being  the  gross  profit  against  which 
general  business  expenses  are  charged,  leaving  as  before  the 
net  profit  for  disposal.    In  these  cases  there  will  still  be  four 


62       ACCOUNTING    PRACTICE    AND    PROCEDURE 

divisions  of  account,  but  neither  of  the  terms  "Trading 
Account"  or  "Manufacturing  Account"  seems  applicable. 
An  analogous  term  "Business  Account"  is  suggested  and 
the  four  divisions  will  be : 

(i)   Business  account 

(2)  Income  account 

(3)  Net  Income  account 

(4)  Profit  and  Loss  account 

In  the  case  of  private  firms  there  will  usually  be  no  profit 
and  loss  account. 

(7)  Private  Accounts 

Private  accounts  are  intended  to  include  only  such  as  do 
not  represent  any  activities.  They  are  the  next  step  to  the 
Net  Income  account  of  activities,  commencing  only  with  the 
share  of  profits  arising  therefrom,  and  by  common  custom 
the  term  Income  and  Expenditure  account  has  long  been 
applied  thereto  and  may  conveniently  be  retained.  One 
account  only  is  required  which  is  credited  with  the  net  in- 
come accruing  and  charged  with  all  the  personal  expendi- 
tures and  other  dispositions,  not  being  additions  to  capital, 
made  thereto,  the  balance  being  carried  to  the  personal 
capital  account  of  the  individual. 

Suggested  Terminology 

In  considering  the  foregoing  accounts  it  is  necessary  to 
note  that  it  is  perhaps  seldom  that  any  of  the  five  classes  con- 
sidered exists  by  itself,  and  to  the  extent  to  which  the  activi- 
ties overlap  so  will  the  accounts  suggested  for  one  group 
appear  also  in  the  other ;  but  the  Net  Income  account  will  be 
the  final  gathering  place  of  all  the  profits  and  losses  for  the 
period  under  review  from  the  various  income  accounts  repre- 
senting different  activities. 


THE    PROFIT    AND    LOSS    ACCOUNT 


63 


The  terms  suggested  for  use  are  thus  confined  to  the 
following : 

(i)  Manufacturing  account,  or 
Trading  account,  or 
Business  account 

(2)  Income  account 

(3)  Net  Income  account 

(4)  Profit  and  Loss  account  (frequently  called  "Sur- 

plus") 

The  term  "Surplus,"  which  is  in  quite  common  use,  is 
better  confined  to  the  surplus  of  assets  over  liabilities,  made 
up,  as  shown  in  balance  sheet  on  page  34,  of  appropria- 
tions for  various  purposes  as  well  as  of  the  balance  of  undis- 
tributed profit  and  loss. 

Of  the  remaining  terms  at  present  variously  used, 
"revenue"  and  "net  revenue,"  are  synonymous  with  "in- 
come" and  "net  income,"  and  are  frequently  so  used,  e.  g., 
in  accounts  of  English  railways  and  in  Government  ac- 
counts ;  it  is  suggested  that  they  are  not  required  and  should 
be  abandoned  entirely.  "Gross  income"  and  "gross  revenue" 
as  names  of  accounts  also  should  be  abandoned  as  useless,  the 
distinction  between  income  and  net  income  being  quite 
sufficient. 

Forms  for  Statements  of  Loss  and  Gain 

The  various  accounts  above  defined  would  usually  be 
prepared  in  debit  and  credit  form.  For  the  better  under- 
standing of  those  interested,  summaries  of  these  accounts  are 
frequently  prepared  in  the  form  of  additions  and  deductions 
under  the  general  heading  of  income  and  profit  and  loss 
account ;  and  the  following  forms  will  be  found  suitable  for 
each  case,  the  further  details  required  being  given  in  exhibits. 


64      ACCOUNTING    PRACTICE    AND    PROCEDURE 

The  forms  up  to  the  point  where  net  profits  are  ascer- 
tained will  be  as  follows : 

Manufacturing  and  Merchandising: 

Gross  earnings  from  sales $ 

Less — Returns,  allowances  and  discount     


Net  earnings  from  sales 

Deduct — Cost   of  production    or   service 

Gross    profit 

Deduct — Cost  of  selling $. 

Expenses  of  management 

Net  profit  from   operations 

Agency  and  Commission: 

Commissions    earned 

Deduct — Expenses  of  management $. 

Cost  of  guarantees 

Net  profit  from  operations 

Transportation: 

Earnings  from  operations 

Deduct — Operating   expenses $. 

Taxes    

Net   profit   from   operations   or   operating 
income    

Banking: 

Earnings  from — 

Interest    $. 

Commissions    

Other  profits    

Deduct — Expenses     of     operation     and 

management    

Net  profit  from  operations 

Professional: 

Gross  earnings  from  fees $. 

Less — Out-of-pocket    expenses    included 

therein   

Net  earnings  from  fees 

Deduct — Expenses     of     operation     and 
management   

Net  profit  from  operations 


THE    PROFIT    AND    LOSS    ACCOUNT  65 

The  form  for  the  remainder  of  the  statement  will  be  the 
same  in  all  cases,  viz. : 

Net  profit  from  operations $ 


Other  income 


Deduct — Interest  on  bonds... 
Other  fixed  charges. 


Surplus  for  the  year 

Extraordinary  profits   (detailed) 

Surplus  brought   forward  from  preceding 
year   


Deduct — Extraordinary   charges. 


Total  surplus  available. 
Dividends  on   stocks... 


Surplus  carried  forward $ . 


Items  Properly  Chargeable  to  Profit  and  Loss 

There  is  a  tendency  to  omit  from  the  account  which 
shows  the  balance  of  the  year  and  charge  to  the  account  of 
undivided  profits  items  of  a  special  character  or  even  of 
an  ordinary  character  which  may  belong  properly  to  a 
previous  period.  As  the  practice  of  charging  to  Profit  and 
Loss  in  preference  to  income  is  to  be  deprecated,  unless  in 
exceptional  cases,  it  may  be  well  to  state  generally  what 
items  may  properly  be  so  charged,  with  the  inference  that 
everything  which  does  not  come  within  this  classification 
should  go  to  either  Income  account  or  Net  Income  account. 
Proper  charges  or  credits  to  Profit  and  Loss  may  be  defined 
as  follows : 

(i)  Extraordinary  items  of  receipt  or  expense  not 
applicable  to  any  particular  year,  such  as  profits  realized  on 
sales  of  property,  or  losses  on  sales  or  dismantlement  of 
property,  or  due  to  its  reconstruction.  The  loss  in  this  class 
of  cases  is  closely  related  to  the  renewal  or  depreciation 


ee      ACCOUNTING    PRACTICE    AND    PROCEDURE 

charges  on  the  same  property,  which  should  properly  go  to 
the  operations  of  a  particular  year.  Frequently  a  property  is 
abandoned  for  purposes  of  reconstruction,  which,  if  it  had 
not  been  for  such  reconstruction,  would  have  remained  in 
service  for  a  long  period  to  come  and  have  been  maintained 
in  a  perfectly  efficient  condition  at  a  small  fraction  only  of 
the  loss  caused  by  its  abandonment.  In  such  cases  it  would 
seem  that  the  proper  distribution  of  the  charges  between  the 
Income  account  and  Profit  and  Loss  account  should  be  to 
charge  to  the  Income  account  so  much  of  the  difference  be- 
tween the  original  cost  and  the  value  at  the  time  of  abandon- 
ment as  has  not  already  been  provided  for  through  charges 
to  income  for  depreciation,  and  to  charge  the  balance — 
namely,  the  difference  between  the  depreciated  value  at  the 
time  of  abandonment  and  the  scrap  value  realized — to  Profit 
and  Loss  account.  This  is  a  principle  fairly  easy  of  applica- 
tion, which  might  well  be  adopted  universally. 

(2)  Discounts  and  premiums  on  bonds.  Discounts  and 
premiums  on  bonds  are  in  effect  an  addition  to  or  deduction 
from  the  interest  rate  paid  on  the  bonds  over  their  life,  and 
as  such  should  strictly  be  included  with  interest  charges  in 
the  net  income  account  by  proper  instalments  each  year.  In 
practice,  however,  it  is  frequently  desired  to  write  off  the 
whole  of  the  discount  at  as  early  a  date  as  possible,  in  prefer- 
ence to  carrying  it  as  a  deferred  and  unrealizable  asset  for 
a  long  period  of  years;  no  objection  can  be  raised  in  such  a 
case  to  providing  for  the  full  amount  out  of  the  surplus 
earnings  of  previous  years.  It  must,  however,  be  remem- 
bered that  such  a  course  conceals  the  true  rate  of  interest 
paid  on  borrowed  money,  the  latter  being  a  factor  of  great 
importance  in  forming  an  opinion  on  the  financial  condition. 

On  the  other  hand,  ordinary  earnings  and  expenses  of 
previous  years  omitted  therefrom  either  by  mistake  or 
because  they  were  at  that  time  incapable  of  ascertainment. 


THE    PROFIT    AND    LOSS    ACCOUNT 


67 


should  invariably  be  included  in  Income  account  and  never 
in  Profit  and  Loss  account.  To  include  them  in  the  latter 
would  preclude  that  account  from  disclosing  over  a  period 
of  years  the  true  result  of  that  -period ;  and  if  in  one  year 
charges  or  credits  have  been  understated  it  necessarily  fol- 
lows that  in  some  other  year  they  must  have  been  corre- 
spondingly overstated. 

Nature  of  Profits 

Before  turning  to  the  consideration  of  the  important 
accounting  principles  involved  in  the  determination  of  the 
values  of  assets  and  the  ascertainment  of  profits,  which 
form  the  subject  of  following  chapters,  the  nature  of  profits 
as  set  forth  in  the  above  statements  and  the  legal  and  general 
principles  involved  in  their  accurate  determination  may  be 
shortly  considered. 

In  the  widest  possible  view,  profits  may  be  stated  as  the 
realized  increment  in  value  of  the  whole  amount  invested  in 
an  undertaking;  and,  conversely,  loss  is  the  realized  decre- 
ment in  such  value.  Inasmuch,  however,  as  the  ultimate 
realization  of  the  original  investment  is  from  the  nature  of 
things  deferred  for  a  long  period  of  years,  during  which 
partial  realizations  are  continually  taking  place,  it  becomes 
necessary  to  fall  back  on  estimates  of  value  at  certain  definite 
periods,  and  to  consider  as  profit  or  loss  the  estimated  in- 
crease or  decrease  between  any  two  such  periods. 

Single-Entry  Determination  of  Profits 

This  method  would  permit  any  business  concern  to  re- 
value periodically  the  whole  of  its  assets  and  liabilities,  and 
to  record  the  difference  between  its  surplus  so  ascertained  at 
the  commencement  and  the  end  of  the  year  as  its  profit  or 
loss,  respectively ;  and  provided  that  this  estimate  were  fairly 
and  reasonably  made,  there  would  be  no  objection  to  such  a 


68      ACCOUNTING    PRACTICE    AND    PROCEDURE 

course.  In  other  words,  every  appreciation  of  assets  is  a 
profit,  and  every  depreciation  a  loss ;  and  in  many  private 
concerns  this  method,  technically  known  as  "single  entry," 
of  ascertaining  profits  has  been  regularly  adopted  for  years 
without  bad  results. 

Corporate  Profits 

A  corporation  being  endowed  by  statute  with  special 
privileges  is  subject  to  special  restrictions,  among  others  that 
of  a  definite  fixed  capital  stock  upon  which  dividends  are 
declared  out  of  the  profits  of  the  undertaking.  Hence,  the 
consideration  of  profits  as  applied  to  a  corporation  involves 
the  consideration  also  of  the  limitations  placed,  either  by 
law  or  by  sound  principles  of  accounting,  upon  their  distri- 
bution as  dividends.  It  is  in  the  legal  interpretation  of  the 
term  "profits  of  a  corporation"  (which  has  come  to  mean 
profits  available  for  dividends),  and  in  the  distinction  be- 
tween the  strictly  legal  and  the  conservative  accounting  view 
of  the  principles  upon  which  they  should  be  ascertained,  that 
the  difficulties  of  the  subject  chiefly  lie. 

Corporate  Profits — English  Rule 

The  law,  represented  mainly  by  case  law,  has  consider- 
ably modified  the  definition  given  above;  and  as  up  to  the 
present  time  a  larger  number  of  cases  have  been  decided  and 
more  definite  results  arrived  at  by  the  English  than  by  the 
United  States  courts,  it  will" be  useful  here  to  consider  briefly 
the  present  condition  of  the  English  law  on  the  subject.  The 
decisions  given  there  have  been  based  on  the  principles  of 
lommon  law  rather  than  on  statutes  relating  to  corporations, 
and  these  decisions  are  freely  quoted  in  American  text  books 
which,  though  in  slightly  different  form,  appear  to  arrive  at 
substantially  the  same  conclusions.  The  summaries  which 
follow  are  given  with  some  hesitation  in  view  of  the  difficulty 


THE    PROFIT    AND    LOSS    ACCOUNT  69 

of  extracting  definite  principles  from  a  number  of  more  or 
less  conflicting  decisions,  but  they  will  at  any  rate  serve  to 
illustrate  the  difficulties  which  have  to  be  met. 

The  regulations  of  a  corporation  in  England  formerly 
provided  that  no  dividends  should  be  paid  except  out  of 
profits  arising  from  the  business  of  the  corporation,  but  in 
article  97  of  the  form  of  Articles  of  Association  given  in 
table  A  of  the  Companies  (Consolidation)  Act,  1908* 
(which  schedule  is  permissible  but  not  compulsory),  the 
words  "arising  from  the  business  of  the  company,"  which 
appeared  in  the  original  table  A  of  the  Companies  Act,  1862, 
are  omitted.  This  change  of  wording  clearly  expresses  the 
present  law  that  all  profits,  however  arising,  may  be  dis- 
tributed as  dividends,  unless  the  regulations  of  the  company 
impose  any  limitation  thereon. 

In  order  to  carry  on  its  business  a  corporation  requires 
certain  capital  or  fixed  assets,  which  must  be  maintained  in 
a  reasonable  state  of  efficiency  as  long  as  the  business  con- 
tinues ;  while  its  profits  or  losses  arise  from  the  employment 
of  its  fixed  assets  in  continuously  changing  the  condition  of 
its  current  or  circulating  assets  from  one  form  to  another, 
and  consist  of  the  difference  between  the  realizable  values  in 
the  final  and  in  the  original  condition,  subject  to  deduction 
of  the  cost  of  the  change  and  the  expenses  of  realization. 

Changes  in  the  value  of  capital  assets  are  not  generally 
realizable  during  the  continuance  of  the  business,  and  hence 
in  the  determination  of  profits  available  for  dividend  under 
the  above  regulation  no  increment  in  the  value  of  its  capital 
assets  can  be  considered;  but  it  would  seem  to  be  legally 
permissible  to  divide  among  stockholders  as  dividend  a 
realized  profit  on  the  sale  of  a  fixed  asset  if  there  were  no 
depreciation  on  other  fixed  assets  to  be  made  good.  On  the 
other  hand,  it  is  not  necessary  to  charge  trading  profits  with 

*See  Appendix  II. 


yo      ACCOUNTING    PRACTICE    AND    PROCEDURE 

any  decrement  of  value  not  due  to  causes  arising  directly  out 
of  the  business ;  but  any  waste  of  fixed  assets  taking-  place  in 
the  operation  of  deriving  profits  out  of  the  circulating  assets 
must,  generally  speaking,  be  made  good  out  of  profits.  There 
is,  however,  a  possible  exception  to  this  rule  when  the  con- 
stitution of  the  corporation  contemplates  the  investment  of 
its  capital  in  certain  specified  wasting  assets,  such  for  in- 
stance as  mines,  and  its  regulations  do  not  call  for  any  pro- 
vision out  of  profits  to  replace  this  waste  by  means  of  a 
sinking  fund  or  otherwise ;  in  such  cases  the  English  courts 
at  one  time  held  that  there  is  no  legal  obligation  to  charge  the 
waste  against  profits  earned  from  the  operations.  The  de- 
cisions referred  to,  viz. :  Lee  v.  Neuchatel  Asphalte  Com- 
pany and  Verner  v.  General  &  Commercial  Investment 
Trust,  have  in  the  later  cases  of  Dovey  v.  Corey  and  Bond  v. 
Barrow  Haematite  Company  been  discredited,  and  the  ten- 
dency of  the  courts  now  appears  to  be  that  provision  must 
be  made  for  any  assets  lost  or  wasted  in  the  process  of  earn- 
ing profits  whether  they  are  fixed  or  circulating.  In  the  last 
case  mentioned  the  court  specifically  held  that  an  amount 
expended  in  mines,  blast  furnaces  and  cottages  which  were 
afterwards  abandoned  must  be  regarded  as  circulating  capital 
and  made  good  before  dividends  could  be  paid. 

In  the  case  of  circulating  assets  the  position  is  clear. 
The  enhancement  in  the  value  of  these  assets  being  the 
source  of  the  profits  of  the  business,  it  is  necessary  and  the 
law  requires  that  they  shall  be  maintained  intact,  and  that 
only  the  surplus  realizable  in  excess  of  the  amount  invested 
is  profit ;  or,  conversely,  that  any  deficit  is  a  loss. 

The  exact  distinction  between  capital  and  current  assets 
depends  necessarily  on  the  nature  of  the  business.  What 
are  capital  assets  for  one  business  may  be  current  assets  for 
another,  according  as  the  business  of  the  corporation  is  to 
make  a  profit  by  using  them  continuously  in  their  existing 


THE    PROFIT    AND    LOSS    ACCOUNT  71 

shape  or  by  converting  them  into  some  other  shape.  For 
instance,  if  a  corporation  owns  investments  for  the  purpose 
merely  of  collecting  the  dividends  thereon,  and  dividing 
these  among  its  stockholders,  it  is  not  legally  bound  to  make 
good  out  of  profits  a  fall  in  the  value  of  the  investments. 
But  if  its  business  were  to  traffic  in  investments,  or  if  it  were 
in  fact  trafficking  in  them,  any  fall  in  value  would  be  a  loss, 
and  any  rise  in  value  a  profit,  chargeable  or  creditable  to 
profit  and  loss. 

Apart  from  the  distinction  between  capital  and  current 
assets  the  following  legal  principles  would  seem  to  be  fairly 
established. 

The  ascertainment  of  profit  being  necessarily  a  matter  of 
estimate  and  opinion,  all  that  is  required  is  that  the  estimates 
be  fairly  and  honestly  made  without  any  fraudulent  intention 
or  purpose  of  deceiving  any  one,  and  that  they  conform  to 
the  constitution  of  the  corporation. 

The  payment  of  interest  to  stockholders  before  any 
profits  have  been  realized  is  stated  to  be  "ultra  vires" ;  but 
interest  paid  on  borrowed  capital  employed  in  the  construc- 
tion of  works,  and  in  the  meantime  unproductive,  may  be 
properly  chargeable  to  capital  account ;  and  by  a  recent  act  of 
Parliament  interest  may  under  certain  restrictions  be  paid 
to  stockholders  during  the  period  of  construction  and  con- 
sidered as  part  of  the  cost  of  the  property.* 

It  also  seems  probable  that  a  corporation  having  made  a 
loss  on  the  operations  of  previous  years,  and  commencing 
the  year  with  a  deficit  in  its  circulating  capital,  may  legally 
distribute  dividends  to  its  stockholders  out  of  the  current 
year's  profit  without  making  good  such  deficit.  In  one  recent 
decision  on  this  point  a  deficit  of  previous  years  is  treated  as 
a  loss  of  capital  assets,  and  it  is  stated  that  the  capital  having 
been  lost,  a  distribution  of  subsequently  earned  profits  can- 

*See  Appendix  IV. 


'J2      ACCOUNTING    PRACTICE    AND    PROCEDURE 

not  be  a  payment  of  dividend  out  of  capital  that  had  been 
previously  lost. 

Corporate  Profits — American  Rule 

The  general  law^  in  the  United  States  as  laid  dov^^n  in 
the  chief  text  books  is  based,  to  a  considerable  extent,  on  the 
decisions  in  the  English  courts. 

Dividends  can  be  paid  only  out  of  profits,  i  .e.,  out  of  the 
net  increase  in  the  original  investment  after  deducting  from 
the  assets  all  present  debts  and  making  provision  for  future 
or  contingent  claims  reduced  to  their  present  value.  But  in 
arriving  at  this  increase  the  permanent  or  fixed  capital  may 
be  valued  at  the  price  actually  paid  for  it,  although  at  the 
time  of  estimating  said  increase  it  could  only  be  sold  at  a 
loss.  All  that  is  required  is  that  the  whole  capital  originally 
contributed  by  the  stockholders  shall  be  put  into  the  business 
and  kept  there,  and  that  no  part  of  it  shall  be  taken  out  again 
directly  or  indirectly  and  given  back  to  them.  On  the  other 
hand,  any  depreciation  due  to  wear  and  tear  arising  out  of 
the  use  of  the  fixed  assets  must  be  made  good  out  of  earnings 
before  the  surplus  can  be  applied  to  the  payment  of  any  divi- 
dend, unless  perhaps  these  fixed  assets  are  of  a  wasting 
nature,  such  as  mines.  There  seems  also  to  be  a  consensus 
of  opinion  that  dividends  can  only  be  paid  out  of  the  surplus 
profits  derived  from  the  use  of  the  capital  of  the  company 
for  those  purposes  for  which  the  corporation  was  con- 
stituted. 

The  statute  laws  vary  in  every  state,  but  the  above  prin- 
ciples seem  to  apply  generally,  with  the  exception  of  certain 
classes  of  business  governed  by  special  laws ;  such  as  banks, 
which  may  not  pay  dividends  out  of  interest  accrued  but  not 
received,  however  well  secured,  and  insurance  companies, 
which  may  not  distribute  unearned  premiums;  and  in  Con- 
necticut it  has  been  held  that  if  at  the  time  of  declaration  of 


THE    PROFIT    AND    LOSS    ACCOUNT 


73 


a  dividend  the  property  is  not  actually  worth  the  par  value 
of  the  stock  which  was  issued  for  it,  the  dividend  is  illegal. 

Corporate  Profits — General  Rule 

From  an  accounting  standpoint,  perhaps  the  only  ex- 
ception that  can  be  taken  to  the  law  as  at  present  interpreted 
is  that  there  is  some  doubt  as  to  whether  the  latter  requires 
the  maintenance  of  wasting  fixed  assets  which  are  used  up 
by  slow  degrees  in  the  process  of  earning  profits.  On 
practical,  if  not  on  theoretical,  grounds,  the  principle  must 
be  accepted  that  a  decrease  in  value  of  fixed  assets  not  of  a 
wasting  character,  arising  otherwise  than  in  the  process  of 
earning  profits,  need  not  be  provided  for.  It  is  true  that  in 
the  long  run  all  shrinkage  of  these  assets  is  a  loss,  and  that 
no  profits  can  be  earned  unless  the  capital,  both  fixed  and 
circulating,  is  maintained  intact.  But  the  changes  in  actual 
values  of  capital  assets  due  to  a  lower  range  of  prices,  the  in- 
troduction of  improved  processes  of  manufacture,  etc.,  may 
be  so  great  and  at  the  same  time  so  indefinite,  and  the  actual 
realization  thereof  is  as  a  rule  deferred  to  such  distant 
periods,  that  it  becomes  quite  impracticable  to  provide  for 
shrinkage  in  value  due  to  such  causes  as  a  direct  charge 
against  profits ;  although  it  is  a  prudent  course  to  accumulate 
a  sufficiently  large  reserve  or  surplus,  and  to  make  such 
liberal  provision  for  depreciation,  as  will  insure  the  integrity 
of  the  investment  and  provide  ample  funds  for  keeping  it 
continually  in  the  highest  state  of  efficiency. 

The  sound  accounting  principles  for  the  determination 
of  profits  may  be  summed  up  as  follows : 

( 1 )  All  waste,  both  of  fixed  and  circulating  assets,  inci- 
dent to  the  process  of  earning  profits  by  the  conversion  of 
circulating  assets  must  be  made  good  out  of  the  profits 
earned. 

(2)  Profits  realized  on  sales  of  fixed  assets  should  be 


74 


ACCOUNTING    PRACTICE    AND    PROCEDURE 


first  applied  to  make  good  estimated  depreciation  (if  any) 
in  other  fixed  assets  not  resulting  from  the  ordinary  conduct 
of  the  business.  If  there  is  no  such  depreciation,  such 
profits  may  be  distributed  as  dividends,  but  should  be  dis- 
tinguished from  the  operating  profits. 

(3)  A  sufficient  surplus  should  be  accumulated  (in  ad- 
dition to  the  provisions  required  to  maintain  wasting  capital 
assets)  for  the  purpose  of  making  good  losses  due  to  shrink- 
age in  values  of  fixed  assets  arising  from  causes  other  than 
the  ordinary  operations  of  the  company.  This  provision 
must,  how^ever,  be  considered  more  a  question  of  policy  than 
a  requirement  of  sound  accounting. 

These  principles  are  best  illustrated  by  a  practical  con- 
sideration of  the  different  elements  which  enter  into  the  de- 
termination of  profits  from  the  viewpoint  of  the  maintenance 
of  assets,  and  a  discussion  of  the  principles  of  valuation 
which  should  be  adopted  for  the  various  assets  and  liabilities 
in  the  balance  sheet,  and  of  the  effect  which  each  would  have 
on  the  profits.  If  the  balance  sheets  at  the  beginning  and 
end  of  a  period  are  theoretically  and  practically  accurate, 
and  show  the  true  financial  position  at  those  dates,  the  in- 
crease or  decrease  of  the  surplus,  after  allowing  for  dis- 
tributions of  profit  during  the  interval,  represents  the  true 
profit  or  loss  for  the  period,  subject  always  to  the  factor  of 
"estimate"  necessarily  present  in  the  valuation  of  assets  and 
liabilities. 

The  detailed  consideration  on  these  lines  of  all  the  ele- 
ments which  must  be  taken  into  consideration  in  determining 
profits  from  an  accounting  standpoint  will  be  taken  up  in  the 
following  chapters. 


CHAPTER   IV 

BALANCE  SHEET  ASSETS 

L     CAPITAL  ASSETS 

(i)   Fixed  Property 

In  the  second  chapter  the  following  distribution  was 
given  of  fixed  assets,  viz. : 

Land   and   improvements   thereon,    including   mineral 

rights  and  development  thereof. 
Buildings  and  structures. 
Plant,  machinery  and  fixed  tools,  permanent  way  of  a 

railroad,  etc. 
Movable  equipment. 
Furniture  and  fixtures. 
Patterns,  drawings,  dies,  etc. 
Patents,  goodwill,  franchises,  etc. 

These  subheadings  are  sufficient  to  give  a  clear  descrip- 
tion of  the  nature  of  all  expenditures  upon  fixed  assets  for 
the  purposes  of  a  balance  sheet,  although  in  the  books  of 
account  themselves  considerably  more  detail  will  be  found 
necessary. 

In  the  correct  determination  of  the  amounts  to  be  carried 
under  any  of  these  headings,  it  is  necessary  to  insure  that 
the  expenditures  included  are  such  as  may  be  properly 
treated  as  additions  to  the  assets;  that  none  are  included 
which  should  properly  be  deemed  renewals  or  replacements 

75 


76      ACCOUNTING    PRACTICE    AND    PROCEDURE 

of  existing  facilities,  and  that  full  provision  has  been  made 
for  all  expenditures  necessary  to  prevent  or  make  good  de- 
preciation due  to  wear  and  tear,  obsolescence  or  other  causes. 
In  the  first  place  it  is  desirable  to  consider  with  some 
care  what  are  the  various  items  of  property  comprised  in 
each  of  these  captions. 

Land  and  Improvements 

Land  and  its  improvements  represent  either  the  own- 
ership in  fee  or  the  enjoyment  under  lease  of  real  estate. 
Here  at  once  arises  a  distinction  of  vital  importance,  in  that 
in  the  former  case  the  valuable  life  of  the  expenditures  is 
coterminous  with  the  life  of  the  improvement,  while  in  the 
latter  it  is  limited  to  a  term  of  years  either  more  or  less  than 
that  life.  Improvements  will  consist  of  all  expenditures  of 
any  kind  that  add  a  long  term  or  permanent  value,  such  as 
levelling  off  for  foundations  for  structures ;  filling  in  swamp, 
or  shallow  water  lands  to  make  them  serviceable;  stripping 
off  surface,  sinking  shafts  or  driving  tunnels  to  make 
minerals  available;  care  and  upkeep  of  growing  trees;  con- 
struction of  embankments,  cuttings,  tunnels,  etc.,  for  the 
permanent  way  of  a  railroad ;  generally  anything  which 
alters  the  shape  or  condition  of  the  land  or  effects  a  per- 
manent change  in  it  and  adds  value.  With  the  exception 
of  mining  expenditures  and  those  upon  growing  timber, 
these  expenditures  are  not  subject  to  depreciation  by  wear 
and  tear,  although  they  may  be  subject  to  provision  for 
obsolescence  or  abandonment. 

Expenditures  upon  development  of  mines  and  those  upon 
the  planting  and  care  of  timber  must  be  considered  specially 
with  regard  to  the  life  of  the  property  in  respect  of  which 
they  are  incurred.  Those  upon  mines  must  follow  the  rules 
laid  down  for  the  minerals  dependent  upon  them  which  are 
discussed  in  Chapter  VII ;  with  the  proviso  that  if  their  life 


BALANCE     SHEET     ASSETS  77 

is  less  than  the  term  over  which  the  exhaustion  of  minerals 
dependent  thereon  would  extend,  they  must  be  written  off  in 
the  shorter  period.  Expenditures  upon  growing  timber  are 
directly  reflected  in  its  increased  size  and  consequent  relative 
value,  though  owing  to  market  conditions  the  actual  value 
of  the  timber  itself  may  be  so  reduced  as  to  offset  or  even 
more  than  offset  the  expenditures.  In  such  cases  it  would 
not  be  safe  to  continue  adding  the  expenditures  to  capital 
account  unless  there  is  a  fair  certainty  that  the  ultimate 
value  when  sold  will  at  least  cover  the  whole  of  the  original 
cost,  subsequent  expenditures  on  care  and  upkeep  and  cost 
of  marketing. 

Both  mines  and  timber  are  subject  to  special  risks  of 
considerable  magnitude,  such  as  fires  and  floods,  which  may 
in  a  short  period  result  in  partial  or  even  entire  destructioru 
Such  catastrophes  can  hardly  be  foreseen,  and  when  they 
arise  must  usually  by  force  of  circumstances  be  dealt  with 
as  losses  of  capital  which  can  only  be  guarded  against 
financially  by  the  creation  of  substantial  reserves  out  of 
profits  previously  earned. 

Buildings  and  Structures 

Buildings  and  structures  will  include  the  cost  of  build- 
ings erected  for  the  purpose  of  housing  people,  animals  or 
property  of  any  kind ;  such  structures  have  a  long  but  termin- 
able life  and  are  therefore  subject  to  regular  depreciation. 

Plant,  Machinery  and  Fixed  Tools 

Plant,  machinery  and  fixed  tools  include  all  the  per- 
manent facilities  required  and  directly  used  in  any  activity; 
which  are  fixed  and  immovable  as  long  as  they  are  in  use 
and  yet  have  to  be  continuously  kept  up  and  replaced  from 
time  to  time.  All  this  class  of  asset  is  subject  to  depreciation 
not  only  for  wear  and  tear  but  for  obsolescence. 


78      ACCOUNTING    PRACTICE    AND     PROCEDURE 

Movable  Equipment 

Movable  equipment  consists  of  all  the  varying  articles 
the  position  of  which  is  not  fixed  but  which  are  continuously 
moved  from  place  to  place  according  to  demands  for  their 
use.  From  their  nature  they  are  subject  to  frequent  replace- 
ment both  for  wear  and  tear  and  loss,  while  the  factor  of 
obsolescence  hardly  exists.  In  many  cases,  in  lieu  of  pro- 
viding for  depreciation,  they  are  treated  as  working  assets, 
all  expenditures,  including  the  amount  necessary  to  reduce 
the  balance  to  an  inventory  value,  being  written  off  to  cost 
of  operations. 

Furniture  and  Fixtures 

The  item  of  furniture  and  fixtures  is  almost  self-explana- 
tory, consisting  of  furniture  in  the  ordinary  sense,  machines 
for  clerical  use,  gas  and  electric  light  fittings  and  other  items 
of  a  similar  nature.  The  asset  is  worth  comparatively  little 
when  its  use  is  abandoned,  and  yet  has  a  fairly  long  life 
while  it  is  in  use.  It  is  usual  to  write  this  asset  down  to  a 
breakup  or  nominal  value,  although  a  smaller  provision  is 
frequently  made. 

Patterns,  Drawings,  Dies,  etc. 

Patterns,  drawings,  dies,  etc.,  are  also  self-explanatory 
and  are  stated  separately  because  their  value  as  an  asset  is 
very  difficult  of  ascertainment ;  and  in-  fact  frequently  merges 
into  the  last  item  of  goodwill.  While  their  use  is  continued 
they  are  worth  their  cost,  but  as  soon  as  by  changes  in  design 
they  cease  to  be  used,  they  are  worth  little  or  nothing;  and 
yet  they  are  an  asset  which  every  manufacturing  business 
must  have  and  which  frequently  represents  large  original 
expenditures. 

As  to  all  these  items  it  may  be  stated  generally  that  it  is 
not  usual  for  a  corporation  to  take  credit  for  a  surplus,  nor 


BALANCE     SHEET     ASSETS  79 

on  the  other  hand  is  it  necessary  for  it  to  charge  itself  with 
a  loss  arising  out  of  a  revaluation  as  long  as  the  property 
valued  is  in  actual  use  for  the  purposes  of  the  business ;  but 
here  it  should  be  noted  that  if  the  business  includes  among 
its  objects  the  purchase  and  sale  of  assets  of  this  class,  they 
should  then  be  considered  not  as  fixed  but  as  current  or  cir- 
culating assets,  being  in  fact  stock  in  trade,  the  turning  over 
of  which  is  expected  to  result  in  profits  or  losses  to  the  com- 
pany. The  fixed  assets  now  under  consideration  are  those 
which  during  the  life  of  the  business  will  remain,  whether 
in  their  present  or  some  other  shape,  in  a  permanent  con- 
dition, provided  that  due  provision  is  made  for  wear  and 
tear  or  other  waste  due  to  operations. 

Patents,  Goodwill  and  Franchises 

The  remaining  items,  patents,  goodwill  and  franchises, 
are  very  much  akin  to  one  another.  Theoretically  it  would 
seem  that  if  a  patent  be  granted  for  a  term  of  years,  the 
amount  paid  for  it  should  be  written  off  against  the  profits 
earned  during  those  years.  But  practically  it  is  found  that 
by  the  time  the  original  patent  has  expired  the  owner  may 
have  built  up  a  virtual  monopoly,  or  at  any  rate  such  a 
lucrative  business  that  the  original  cost  of  the  patent  is  now 
replaced  by  the  reasonable  value  of  the  goodwill.  More- 
over, it  is  seldom  the  case  that  one  patent  stands  by  itself; 
during  its  life  probably  many  others  have  been  taken  out, 
representing  modifications  which  extend  the  life  of  the 
original  in  an  improved  form,  and  these  may  have  cost  small 
sums  as  compared  with  the  very  much  larger  cost  of  the 
original. 

Goodwill  represents  the  value  of  the  trade-name,  busi- 
ness connection  and  organization  of  the  undertaking.  As 
long  as  the  earnings  of  the  business  are  maintainable  at  not 
less  than  the  level  contemplated  at  date  of  purchase,  it  is 


8o      ACCOUNTING    PRACTICE    AND    PROCEDURE 

impossible  to  allege  any  depreciation  of  value  or  the  neces- 
sity of  any  provision  therefor.  On  the  other  hand,  if  any 
serious  depreciation  has  taken  place,  the  profits  are  probably 
so  much  reduced  that  it  is  not  practicable  to  make  such  pro- 
vision. Goodwill  is  in  fact  a  fixed  asset  whose  value  is  to 
some  extent  dependent  upon  the  profits  earned,  its  fluctua- 
tions being-  consequent  upon  and  not  a  cause  of  the  earning 
of  profits,  as  are  wasting  or  partially  wasting  assets,  and 
not  therefore  to  be  taken  into  account  in  ascertaining  them. 

Franchises  may  be  either  perpetual  or  for  a  fixed  term. 
In  the  former  case,  the  same  considerations  would  apply  as 
in  the  case  of  goodwill.  In  the  latter  case,  they  may  be 
renewed  or  terminated  at  the  expiry  of  the  fixed  term,  and 
prudence  would  dictate  a  reasonable  provision  each  year 
by  a  charge  to  Profit  and  Loss  account,  although  no  definite 
amount  may  be  ascertainable. 

Provided,  therefore,  that  the  wise  policy  is  followed  of 
writing  off  at  once  all  expenditure  on  new  patents  which 
do  not  turn  out  useful,  or  which  supersede  or  modify  older 
ones,  and  provided  also  that  the  principle  is  admitted  of 
building  up  a  substantial  reserve  fund  against  whatever  por- 
tion of  the  capital  is  invested  in  this  class  of  assets,  it  would 
seem  reasonable  to  merge  the  three  items  into  one  and  treat 
them  as  part  of  the  permanent  invested  capital  of  the  busi- 
ness, which  may  be  left  to  continue  at  its  original  value  as 
long  as  the  business  is  a  going  concern. 

Changes  in  Value  of  Capital  Assets 

It  is  necessary  to  recognize  that  there  are  causes  at  worK, 
particularly  in  young  and  growing  communities,  which  may 
render  a  statement  prepared  on  the  basis  of  cost  of  capital 
assets  misleading  and  even  prejudicial  to  the  proper  interests 
of  present  owners.  Over  a  period  of  years  changes  in  value 
due  to  rise  or  fall  in  prices  may  be  sufficiently  permanent 


BALANCE    SHEET    ASSETS  gl 

to  render  it  unfair  to  one  business  to  maintain  original  cost 
values  as  compared  with  another  whose  assets  have  been 
created  at  widely  varying  costs.  Moreover,  even  where  con- 
structed works  may  have  fallen  in  value  owing  to  deprecia- 
tion or  obsolescence  which  has  not  been  provided  for,  there 
may  be  an  offsetting  increase  in  the  values  of  land  and  its 
subsoil  or  other  natural  products  due  to  the  development  of 
the  community  and  consequent  largely  increased  demand.  It 
is  true  that  from  the  point  of  view  of  earnings  such  incre- 
ment can  not  be  taken  as  in  any  way  a  proper  offset  to  losses 
due  to  wear  and  tear,  depreciation  or  obsolescence ;  but  this 
does  not  alter  the  fact  that  in  spite  of  an  insufficient  pro- 
vision for  depreciation  on  some  assets,  there  may  be  an 
actual  increase  on  the  total  value  of  all  assets.  In  fact, 
there  are  well-known  cases  in  which  by  far  the  larger  part 
of  the  ultimate  profits  of  a  corporation  over  a  long  series 
of  years  has  been  due  not  to  the  results  of  its  activities  but 
to  the  large  unearned  increment  on  its  capital  assets.  This 
condition  must  be  recognized  and  is  frequently  met  by 
means  of  careful  appraisals  of  all  properties,  the  resulting 
increase  (or  possibly  decrease)  being  taken  up  as  a  special 
credit  or  debit  to  Profit  and  Loss  account  (or  Surplus)  and 
shown  as  entirely  distinct  from  the  operating  results. 

In  the  case,  too,  of  the  sale  of  a  portion  of  the  capital 
assets  it  may  be  entirely  legitimate  to  take  up  any  profit  just 
as  it  may  be  necessary  to  provide  for  a  loss.  This  may  be 
done  by  means  of  an  appraisal  of  the  portion  of  the  property 
remaining  unsold,  the  difference  between  this  figure  and  the 
book  figure,  after  deduction  of  the  sale  price  of  the  portion 
sold,  being  treated  as  the  estimated  profit  or  loss  arising  on 
the  sale  and  appraisal.  This  being  divided  proportionately 
to  the  sale  and  appraisal  figures,  the  former  will  represent 
the  approximate  profit  or  loss  on  the  sale.  It  is  undoubtedly 
more  conservative  to  treat  profits  so  arising  as  a  capital  re- 


82   ACCOUNTING  PRACTICE  AND  PROCEDURE 

serve  available  to  meet  possible  losses  from  further  sales  or 
ultimate  realization,  while  losses  if  clearly  ascertained  would 
be  written  off  either  at  once  against  past  surplus  or  by  instal- 
ments against  future  earnings.  There  are,  however,  cases  in 
which  a  surplus  exists  beyond  all  reasonable  doubt  and  no 
objection  can  be  taken  to  treating  at  any  rate  a  substantial 
portion  thereof  as  realized  and  divisible.  It  is  always  diffi- 
cult to  come  to  a  decision  as  to  the  best  treatment  in  cases  of 
this  kind ;  as  in  many  others,  each  must  be  considered  on  its 
merits,  with  due  regard  to  safety  in  finance  and  justice  to  the 
varying  interests  of  present  and  future  owners. 

In  any  case  in  which  such  a  surplus  on  revaluation  is 
credited  to  Profit  and  Loss  account  (or  Surplus)  it  is  most 
important  that  the  amount  be  clearly  distinguished  from 
earnings  from  operations,  with  a  full  description  of  its 
nature. 

(2)  Permanent  Investments 

This  class  of  investment,  which  in  the  form'  of  balance 
sheet  submitted  in  Chapter  II  is  considered  as  part  of  the 
fixed  assets,  may  be  generally  defined  as  investments  which 
control  some  essential  part  of  the  activities  carried  on. 
They  may  consist  of  actual  ownership  of  stocks  or  bonds, 
interest  in  a  partnership,  or  advances  by  way  of  loan  or 
on  current  account  to  affiliated  undertakings.  The  dis- 
tinction between  these  and  marketable  investments,  which 
latter  are  included  among  current  assets,  is  that  the  former 
cannot  be  sold  without  in  some  way  affecting  the  activities 
of  the  owner,  while  the  latter  representing  merely  the 
temporary  deposit  of  surplus  working  capital  can  be  dis- 
posed of  at  any  time  without  in  any  way  affecting  such 
activities.  The  distinction  is  a  most  important  one  and  has 
an  equally  important  bearing  on  the  financial  position  of  an 
undertaking  by  reason  of  the  fact  that  the  investment  in  the 


BALANCE     SHEET     ASSETS 


83 


former  class  of  a  portion  of  the  current  assets  withdraws 
those  assets  from  the  general  use  of  the  business  and  pre- 
vents their  use  for  the  purpose  for  which  current  assets  are 
intended,  viz. :  the  conversion  as  rapidly  as  may  be  from 
cash  into  products  for  sale  and  so  back  into  cash  again. 
The  conversion  of  any  part  into  assets  of  a  permanent  nature 
diminishes  .the  current  assets  and  can  only  be  offset  either 
by  reducing  operations  or  increasing  liabilities,  unless  of 
course  the  current  assets  are  in  the  first  instance  more  than 
sufficient  for  all  needs.  If  permanent  investments  are  in- 
cluded in  current  assets,  it  is  impossible  to  get  a  clear  view 
of  the  facts. 

The  ease  of  conversion  of  investments  into  cash  is  not 
the  sole  test  that  should  be  employed  in  distinguishing  be- 
tween permanent  and  marketable  investments,  the  possi- 
bility of  conversion  without  diminishing  or  hampering  the 
business  activities  of  the  owner  being  an  even  more  im- 
portant one.  The  following  instances  of  permanent  invest- 
ments will  perhaps  better  elucidate  this  point. 

Investments  for  Purposes  of  Control 

The  first  class  would  include  those  held  for  the  purpose 
of  controlling  the  operations  of  another  business  and  may 
consist  of  any  interest  therein  which  carries  a  majority  vote ; 
or  even  the  whole  interest  with  the  exception  in  the  case  of 
a  corporation  of  the  few  shares  necessary  to  constitute  a 
sufficient  number  of  shareholders. 

Where  the  interest  owned  is  the  whole,  or  substantially 
the  whole,  the  best  treatment  is  to  consolidate  the  balance 
sheets  of  all  such  interests  with  that  of  the  owner  in  the  form 
known  as  a  consolidated  balance  sheet,  in  which  the  assets 
and  liabilities  of  all  are  aggregated  under  their  proper  head- 
ings, and  the  particular  asset  of  "permanent  investments,"  so 
far  as  those  interests  are  concerned,  disappears.  This  method 


84       ACCOUNTING    PRACTICE    AND    PROCEDURE 

which  avoids  many  awlsward  questions  is  dealt  with  in  some 
detail  in  Chapter  VIII. 

When  the  interest  owned  is  less  than  a  substantial  whole 
but  still  a  controlling  interest,  this  treatment  should  not  be 
adopted  but  the  investment  should  then  be  treated  as  an 
asset.  The  controlling  factor  in  its  valuation  is  the  actual 
cost  which  must  be  assumed  to  be  the  result  of  a  bargain. 
Subsequent  changes  in  this  value,  apart  from  additions  to 
or  withdrawals  of  the  capital  invested,  will  be  due  either 
to  profits  or  losses  made  in  its  operationr  or  to  appreciation 
or  depreciation  of  its  assets  due  to  other  causes.  The  pro- 
portion of  the  former  corresponding  to  the  interest  owned 
should  always  be  taken  up  in  the  Income  account  of  the 
owner;  and  this  is  best  done  by  adding  to  or  deducting  from 
the  investment  the  amount  of  such  profits  and  losses  and 
crediting  or  debiting  the  same  to  Income  account.  The 
argument  in  favor  of  this  course  is  that  the  investment  itself 
from  an  operating  point  of  view  is  better  or  worse  than  at 
the  commencement  of  the  period  by  the  profit  or  loss  made. 
If  dividends  are  subsequently  declared  and  paid,  they  will 
be  credited  not  to  Income  account  but  to  the  investment  ac- 
count for  the  reason  that  the  investment  itself  is  worth  so 
much  less  on  account  of  the  assets  thus  withdrawn.  Appre- 
ciation or  depreciation  due  to  causes  other  than  operation 
should  be  treated  exactly  as  in  the  case  of  that  of  other 
fixed  assets  already  discussed;  the  data  for  such  being 
obtained  from  a  critical  investigation  of  the  property  and 
other  assets  and  of  the  liabilities  of  the  particular  sub- 
interest.  The  reason  for  adding  profits  to  the  investments 
instead  of  treating  them  as  a  current  asset,  is  that  there  is 
no  possibility  of  receiving  them  as  profits  until  a  dividend 
is  declared ;  and  further  that  for  good  reasons  these  profits 
may  be  employed  in  the  extension  of  the  business  of  the 


BALANCE     SHEET     ASSETS 


85 


subinterest,   leaving  no  current  assets   available  >for  the 
declaration  of  a  dividend. 

Investments  Controlling  Facilities  or  Output 

The  second  class  of  permanent  investment  would  include 
those  which  are  held  to  secure  some  portion  of  the  output 
of  the  subinterest  or  other  facilities,  such  as  through  routing 
of  traffic  of  a  railroad,  which  it  is  necessary  for  the  owner  to 
possess.  The  ownership  in  such  cases  may  be  only  a  small 
proportion  of  the  total  capital  of  the  subinterest  and  may 
be  readily  saleable  at  any  time  to  other  owners  or  to  out- 
siders ;  but  its  sale  would  cut  off  important  connections 
and  therefore  interfere  to  a  measurable  degree  with  the 
owner's  activities  and  for  this  reason  it  will,  unless  some 
change  of  policy  takes  place,  be  held  permanently  and  not 
sold.  It  would  clearly  be  misleading  to  treat  such  invest- 
ments as  current  assets  and  in  most  cases  they  may  be  valued 
at  cost  rather  than  at  market  value.  Full  consideration  is 
required  of  all  the  surrounding  conditions  in  each  case,  and 
if  there  is  reasonable  doubt  as  to  cost  representing  the 
present  value  of  the  facilities  or  connections  which  the  in- 
vestment controls,  then  proper  reserves  should  be  made.  It 
frequently  happens  that  no  profits  are  made  by  such  sub- 
interests,  the  products  being  shared  in  proportion  to  the 
respective  ownerships  and  charged  to  them  at  a  price  to 
exactly  cover  cost  and  fixed  charges. 

Minor  Investments 

The  third  class  would  consist  of  small  interests  owned 
for  various  business  purposes.  Such  investments  are  in  the 
ordinary  sense  "marketable,"  but  for  the  very  reason  for 
which  they  are  owned  will  not  be  marketed  unless  a  change 
of  policy  occurs;  therefore  they  should  be  treated  as 
permanent.    The  rule  for  treatment  of  dividends  and  values 


86      ACCOUNTING    PRACTICE    AND    PROCEDURE 

would  be  the  same  as  for  marketable  investments,  although 
no  great  objection  could  be  taken  to  carrying  them  at  cost 
until  realized. 

Non-Income  Producing  Investments 

The  fourth  class  would  consist  of  interests  owned  purely 
for  business  purposes  but  not  producing  income,  such  as 
stock  exchange  and  board  of  trade  memberships,  and  de- 
posits with  governments  which  must  be  maintained  as  long 
as  the  business  is  conducted  on  the  same  lines.  These  are 
usually  of  fixed  cash  values  and  have  no  dividends  or  other 
income  accruing,  except  possibly  interest  on  deposits,  which 
would  in  the  ordinary  course  be  credited  direct  to  Income 
subaccount.  No  special  question  arises  in  connection  with 
such  investments. 

Advances 

The  fifth  class  would  consist  of  advances  made  for  the 
purpose  of  acquiring  or  constructing  additional  properties, 
the  ultimate  ownership  of  which  is  uncertain.  They  may 
eventually  be  absorbed  entirely  by  the  owner;  they  may  be 
turned  over  to  a  separate  corporation  of  which  he  will  own 
the  stock,  and  the  outlays  may  be  repaid  out  of  proceeds  of 
bonds  issued  by  such  corporation;  they  may  become  joint 
ownerships  of  some  kind,  or  they  may  be  finally  disposed  of 
altogether.  Such  advances  are  usually  found  in  the  first 
instance  buried  among  accounts  receivable,  but  it  is  evident 
that  this  is  not  a  proper  place  for  them,  as  whatever  final 
disposition  is  made  they  remain  a  suspended  asset  for  the 
time,  generally  considerable,  necessary  to  complete  the  mat- 
ter. They  should  be  eliminated  entirely  from  current  assets 
and  carried  in  permanent  investments,  or  a  subheading 
thereof  denoted  "advances,"  until  such  time  as  they  are 
again  converted  into  a  liquid  form.     Frequently  interest  is 


BALANCE     SHEET     ASSETS  Sy 

added  to  such  investments  during  the  time  they  are  carried 
and  this  course  may  or  may  not  be  legitimate  according 
to  the  circumstances.  In  the  case  in  which  they  represent 
actual  new  construction  the  rules  as  to  the  disposition  of 
this  interest  are  the  same  as  in  the  case  of  any  other  capital 
asset ;  but  if  the  advances  are  made  to  an  operating  property 
whose  earnings  are  not  sufficient  to  meet  the  interest,  the 
amount  so  added  should  be  carried  to  a  credit  suspense  ac- 
count until  such  time  as  it  is  earned  and  not  to  the  credit  of 
Income  account  where  if  earned  it  would  naturally  find  a 
place.  In  the  meantime,  in  preparing  the  balance  sheet 
this  credit  suspense  account  should  be  treated  as  a  reserve 
against  the  investment  and  deducted  therefrom.  All  such 
advance  accounts  require  continual  supervision  to  insure 
that  they  are  alive  and  represent  property,  and  are  not 
mere  depositories  for  losses  or  expenditures  which  are  of 
no  permanent  value  and  should  be  written  off  as  incurred. 

(3)  Investment  of  Reserves 

It  is  a  common  practice  to  make  special  investment  of 
the  funds  set  aside  for  the  different  voluntary  reserves  in- 
cluded under  the  main  heading  of  surplus.  As  the  variation 
in  the  value  of  the  investments  affects  only  the  reserves 
themselves,  and  losses  or  profits  can  not  be  definitely  ascer- 
tained until  the  reserves  are  required  and  the  investments 
sold,  it  is  common  to  maintain  these  investments  at  cost, 
ignoring  any  appreciation  or  depreciation.  Provided  that 
the  fluctuations  in  value  are  of  a  temporary  nature  and  of 
small  relative  amount,  no  objection  need  be  taken  to  this 
proceeding;  but  any  material  or  permanent  change  in  value 
ought  to  be  reflected  in  an  adjustment  both  of  the  reserve 
and  the  investment. 

Another  question  arises  where  these  reserves,  as  is  fre- 
quently the  case,  are  invested  in  the  securities,  either  stocks 


88   ACCOUNTING  PRACTICE  AND  PROCEDURE 

or  bonds,  of  the  corporation  itself.  There  seems  no  reason 
to  depart  from  the  principle  laid  down  for  ordinary  invest- 
ments of  the  corporation  (Chapter  VI)  that  any  invest- 
ments of  this  nature  should  be  eliminated  both  from  the 
asset  "Investment  of  Reserves"  and  from  the  liability  on 
the  particular  class  of  security.  The  contrary  treatment  is 
frequently  adopted  on  the  ground  that  these  investments 
are  readily  saleable  and  therefore  immediately  convertible 
into  cash  when  required.  It  is  impossible,  however,  to 
ignore  the  fact  that  until  such  sale  is  made  the  reserves  are 
actually  invested  not  in  outside  securities  but  in  the  under- 
taking and  business  of  the  corporation.  This  may  be  good 
or  bad  policy  according  to  the  facts  or  conditions,  but  it 
does  not  seem  correct  to  maintain  the  fiction  of  an  outside 
investment  under  such  circumstances.  It  may  easily  be 
that  when  the  reserves  are  most  urgently  required  by  reason 
of  some  sudden  disaster  these  securities  may  be  saleable  only 
at  a  very  heavy  depreciation  or  even  entirely  unsaleable. 

Generally,  therefore,  it  may  be  said  that  "Investment 
of  Reserves"  should  include  only  outside  investments,  with 
the  addition  to  the  heading  of  some  such  phrase  as  "In  addi- 
tion to bonds  or  stock  of  the  corporation  of  a  par 

value  of  $. " 

II.     WORKING  ASSETS 

Working  assets  are  grouped  under  the  following  cap- 
tions : 

Stores  and  supplies  for  use  in  operations. 
Money  in  hands  of  agents  for  business  purposes. 
Insurance,  interest,  taxes,  royalties,  etc.,  paid  in  ad- 
vance of  the  period  over  which  they  accrue. 
Working  assets,  as  already  stated,  are  those  which  are 
consumed  in  the  activities  carried  on  without  themselves 


BALANCE     SHEET     ASSETS  89 

forming  an  integral  part  of  the  products.  It  follows  that 
no  questions  of  profit  or  loss  should  be  involved  in  the  ascer- 
tainment of  their  proper  values  except  such  as  arise  from 
changes  of  value  due  to  fluctuations  in  prices  or  to  deprecia- 
tion. On  the  other  hand,  the  quantities  and  money  values 
are  continually  changing  and  must  therefore  be  accurately 
determined  whenever  a  balance  sheet  is  prepared. 

(i)   Stores  and  Supplies 

In  any  good  system  of  bookkeeping,  accounts  will  be  kept 
for  all  the  items  included  in  the  last  two  groups,  and  fre- 
quently also  there  will  be  a  book  account  for  Stores  and  Sup- 
plies ;  when  no  such  account  is  kept  an  inventory  of  the  latter 
must  be  taken.    This  inventory  requires: 

(i)   An  accurate  determination  of  the  quantities  on 
hand,  which  involves  no  important  question. 

(2)  A  determination  of  the  price  at  which  the  quanti- 

ties shall  be  valued. 

(3)  A  sufficient  allowance  for  depreciation  in  value  due 

to  age,  deterioration  or  obsolescence. 

The  price  would  in  the  ordinary  course  be  the  actual 
cost  of  purchase,  which  would  also  be  the  value  at  which 
the  consumption  would  be  charged  to  costs  of  operation  in 
the  future.  This  price,  however,  would  be  subject  to  adjust- 
ment if  the  market  value  had  fallen  below  cost,  although  any 
adjustment  in  this  respect  is  in  the  nature  of  a  reserve  in 
favor  of  the  cost  of  production  in  the  next  period  and  is 
not  a  factor  in  the  cost  of  production  of  the  past.  Such 
reserves  should  be  made,  therefore,  specifically  out  of  net 
profits,  and  actual  cost  maintained  on  the  books  and  used 
in  subsequent  operation;  the  reserve  being  credited  back  to 
Income  account  in  the  succeeding  period. 


90   ACCOUNTING  PRACTICE  AND  PROCEDURE 

It  is  very  important  that  reserves  be  made  for  unusable 
or  damaged  stock,  preferably  by  a  direct  charge  into  costs, 
as  deterioration  of  such  character  is  an  incident  of  pro- 
duction or  operation.  It  is  further  important  as  a  matter 
of  economy  of  operation  that  the  stocks  carried  be  not  al- 
lowed to  accumulate  beyond  the  needs  of  the  business,  as 
such  accumulation  is  bound  to  lead  to  waste  and  loss  by 
deterioration  or  otherwise.  Such  accumulations  are  fre- 
quently evidence  of  carelessness  or  even  dishonesty  on  the 
part  of  those  responsible. 

(2)  Advances  to  Agents 

The  caption  of  "Advances  to  Agents"  should  include  all 
cash  items  or  the  equivalent  which  are  permanently  or  tem- 
porarily locked  up  for  business  purposes  and  are  not  free 
cash ;  such  as  balances  left  in  hands  of  agents  for  special 
purposes,  which  are  in  process  of  being  spent  and  will  not 
be  accounted  for  until  the  purpose  is  accomplished ;  or  de- 
posits made  in  connection  with  bids  made  or  contracts 
undertaken.  These  would  all  be  entered  at  their  book  value 
subject  to  any  known  loss  or  depreciation.  It  is  desirable 
that  each  of  these  items  shall  be  cleared  at  a  balance  sheet 
period  and  the  book  balance  adjusted  to  an  actual  asset 
value  after  writing  off  any  portion  that  may  have  been  ex- 
pended. This  practice  should  be  adopted  wherever  practi- 
cable, but  there  are  many  cases  where  either  the  work  in- 
volved would  not  justify  the  result  or  where  for  other 
reasons  such  a  course  is  inconvenient.  Provided  that  the 
accounts  are  all  carefully  scrutinized  at  short  intervals  and 
always  at  a  balance  sheet  period,  all  known  adjustments 
made  and  no  accumulation  of  unexplained  balances  allowed, 
practical  accuracy  is  obtained  by  leaving  the  remainder 
temporarily  unadjusted  and  including  them  under  this  cap- 
tion in  the  balance  sheet.    Such  accounts  being  in  the  nature 


BALANCE     SHEET     ASSETS  9I 

of  suspense  accounts,  always  require  very  special  attention 
for  the  reason  that  they  may  if  neglected  become  a  receptacle 
for  improper  or  fraudulent  entries  which  might  remain  for 
a  long  time  undiscovered.  Independent  evidence  of  the  ex- 
istence and  character  of  the  accounts,  in  the  form  of  certifi- 
cates or  correspondence,  is  nearly  always  available  and 
should  be  in  the  possession  of  those  in  charge  of  the  ac- 
counts. 

(3)  Expenses  Incurred  in  Advance  of  Accrual 

The  third  class  of  items  strictly  consists  of  expenses 
which  have  been  incurred  in  advance  of  accrual;  they  are 
treated  as  assets  for  the  purpose  of  keeping  the  transactions 
of  each  period  separate,  and  because  they  are  to  be  met  out 
of  the  profits  on  future  operations.  They  will  consist  either 
of  expenses  paid  in  advance  of  due  or  accruing  dates,  or 
of  those  which  are  due  and  accrued  but  relate  to  operations 
not  yet  completed,  although  not  part  of  the  direct  cost  of 
such  operations  nor  of  the  value  of  the  resulting  products. 

It  will  be  found  in  the  next  chapter  that  merchandise  on 
hand  should  be  valued  at  cost  of  production,  not  including 
cost  of  sale.  There  are,  however,  special  cases  in  which 
it  may  be  fair  and  reasonable  to  carry  forward  some  pro- 
portion of  selling  expenses  incurred  to  a  subsequent  period 
in  which  the  results  therefrom  are  expected.  Thus  the  cost 
of  advertising  a  newly  started  business  may  frequently  be 
largely  in  excess  of  any  immediate  results  expected  or 
realized,  and  it  may  be  desired  to  carry  forward  a  proportion 
of  such  expenses  as  a  charge  against  the  results  of  subse- 
quent periods.  Interest  or  other  charges  incurred  in  carry- 
ing assets  of  any  kind  that  require  time  for  their  full  de- 
velopment and  conversion  into  a  shape  in  which  they  can  be 
sold;  charges  incurred  on  account  of  operations  pending 
and  not  completed,  and  the  profit  or  loss  upon  which  can 


92   ACCOUNTING  PRACTICE  AND  PROCEDURE 

not  at  the  moment  be  ascertained,  such  as  uncompleted 
voyages  of  ships ;  royalties  paid  in  excess  of  mineral  worked 
and  recoverable  out  of  any  excess  worked  in  future  years 
over  the  minimum ;  these  and  many  other  similar  items  find 
their  natural  place  in  this  category.  In  every  case  the 
greatest  care  is  necessary  to  see  that  all  items  so  carried 
forward  are  not  only  reasonable  but  safe,  in  that  at  least 
the  amount  carried  forward  will  be  recovered  or  provided 
for  within  a  reasonable  period. 

The  item  of  royalties  deserves  special  consideration.  It 
is  a  frequent  custom  to  provide  for  the  payment  of  a  royalty 
based  on  the  tonnage  produced  but  with  a  fixed  minimum 
payment.  In  the  early  years  of  development  it  may  well 
happen  that  the  tonnage  mined  is  not  equal  to  the  minimum 
upon  which  royalties  are  payable,  and  provision  is  often 
contained  in  the  lease  that  the  excess  royalty  so  paid  may 
be  set  off  against  that  due  on  tonnage  worked  in  excess  of 
the  minimum  in  subsequent  years.  The  value  of  this  excess 
royalty  paid  will  depend  upon  the  quantity  of  workable 
mineral,  the  term  of  the  lease,  and  the  probable  annual 
production ;  and  unless  there  is  a  reasonable  probability  of 
working  a  tonnage  in  excess  of  the  minimum  during  a  suffi- 
cient number  of  years  before  the  expiry  of  the  lease  to 
offset  the  shortages  in  earlier  years,  no  value  can  be  at- 
tached to  the  asset. 

It  is  hardly  practicable  to  lay  down  any  specific  principles 
upon  which  the  assets  which  may  be  included  under  this 
caption  should  be  valued.  Each  case  must  be  considered  on 
its  merits  and  with  regard  to  its  reasonable  and,  above  all, 
safe  value,  so  that  the  risk  of  carrying  an  item  at  a  value 
which  can  not  ultimately  be  realized  or  provided  for  out  of 
the  margin  of  profits  to  be  realized  in  the  contemplated 
operations,  may  as  far  as  possible  be  eliminated. 


CHAPTER  V 

BALANCE  SHEET  ASSETS  (Continued) 

III.     CURRENT  ASSETS 

(i)  Stocks  on  Hand.  (Materials  carried  for  sale  or  con- 
version, and  products  partly  or  wholly  manufactured  in- 
tended for  sale.) 

The  enumeration  and  valuation  of  stocks  on  hand  is  a 
matter  of  considerable  difficulty  and  involves  many  im- 
portant questions. 

Profits  can  only  be  made  out  of  the  sale  or  exchange  of 
one  commodity  for  another  of  a  definite  and  realizable  cash 
value.  The  mere  increase  in  the  market  value  of  an  article 
which  is  not  actually  sold,  can  not  be  considered  as  a  profit ; 
for  the  reason  that  the  article  may  never  be  sold  at  that 
price,  and  the  paper  profit  may  never  be  realized.  The 
object  of  the  Profit  and  Loss  account  of  a  manufacturing 
or  merchandising  concern  is  to  ascertain  as  closely  as  possi- 
ble the  profits  which  have  been  realized  on  sales  actually 
made;  and  for  this  reason  raw  materials  on  hand,  and 
products  partly  or  wholly  manufactured,  but  not  sold,  should 
be  entirely  eliminated.  In  practice  this  result  is  obtained 
by  valuing  them  at  cost,  no  more  and  no  less,  and  so  exactly 
offsetting  the  charges  to  Manufacturing  account  for  ma- 
terials, labor  and  expenses,  in  so  far  as  the  result  of  their 
combination  in  manufacturing  processes  is  still  uncompleted 
and  unsold- 

93 


94   ACCOUNTING  PRACTICE  AND  PROCEDURE 

On  the  other  hand,  a  balance  sheet  is  required  to  show 
the  true  financial  position  as  a  going  concern.  The  inven- 
tory at  actual  cost  may  represent  more  or  less  than  the 
market  value,  and,  therefore,  overstate  or  understate  the 
assets ;  but  to  change  the  valuation  would  be  to  take  up  r 
profit  or  provide  for  a  loss  which  might  never  be  realized 
owing  to  subsequent  changes  in  the  market  value.  Sound 
commercial  principles  require  that  no  credit  be  taken  for 
profits  until  they  are  realized;  but  further,  that  if  there  is 
any  possibility  that  what  remains  unsold  may  not  realize  its 
cost,  a  proportion  of  the  realized  profits  on  sales  which 
have  been  made,  should  be  carried  forward  to  cover  these 
possible  losses.  It  is  accordingly  generally  recognized  as  a 
correct  accounting  principle  that  if  the  cost  value  of  the 
inventory  exceeds  the  market  value,  a  reserve  should  be 
created  to  bring  it  down  to  the  latter  value,  while,  on  the 
\5  other  hand,  if  the  market  value  exceeds  the  cost,  no  credit 
o  should  be  taken  for  the  profits  until  they  are  realized  by  an 
\^  1  actual  sale.  This  rule  is  of  considerable  importance  where 
>^  ;  the  inventories  at  the  end  of  successive  years  show  a  pro- 
5  gressive  increase.     If  they  be  valued  above  cost,  profits  are 

shown  in  each  year,  which  are  an  anticipation  of  those  of 
succeeding  years,  and  a  large  asset  is  created  which,  on  a 
subsequent  fall  in  market  prices,  may  prove  unrealizable. 

It  should  be  noted  that  it  is  not  essential,  and  in  fact  it 
would  frequently  be  incorrect,  to  value  materials  and  prod- 
ucts on  hand  at  the  end  of  the  fiscal  period  upon  the  same 
price  basis  as  at  the  commencement  of  that  period ;  all  that 
is  necessary  or  proper  is  that  the  basis  of  valuation — that  is 
to  say,  the  principles  on  which  the  values  are  arrived  at — 
should  be  the  same  at  the  beginning  and  end  of  the  period, 
the  actual  prices  usually  varying  from  one  year  to  another. 
Unfortunately,  in  practice,  many  concerns  are  unable  to 
ascertain  the  cost  of  their  various  products,  with  the  result 


BALANCE     SHEET     ASSETS  95 

that  their  stock  valuations  are  based  entirely  on  estimates  of 
costs  made  with  more  or  less  accuracy.  There  does  not 
appear  to  be  any  legal  obligation  on  a  corporation  to  adopt 
any  particular  basis,  provided  that  the  price  adopted  is  not  in 
excess  of  that  ultimately  realized  after  deduction  of  any 
subsequent  cost  of  completion,  storage  and  sale;  but  the 
absence  of  knowledge  as  to  the  approximate  cost  not  in- 
frequently leads  to  disappointment  to  the  owners,  and  even 
to  serious  financial  loss.  It  is  obvious  that  a  constantly 
changing  basis  of  cost  must  lead  to  serious  inequalities  in 
the  profits  shown  between  one  period  and  another,  but  it  is 
not  equally  obvious  that  an  erroneous  basis  of  valuation  con- 
sistently adopted  year  after  year,  even  if  that  basis  be  a 
conservative  one  and  really  below  true  cost,  may  result  in 
large  and  unexpected  discrepancies  between  the  profits 
shown  in  different  periods.  For  instance,  if  stocks  be  valued 
on  a  basis  exceeding  cost,  and  if  the  trade,  and  consequently 
the  materials  and  products  on  hand,  increase  very  rapidly 
for  one  or  more  years,  the  profits  during  those  years  of  in- 
crease will  be  abnormally  inflated ;  but  when  the  trade  settles 
down  to  a  comparatively  steady  turnover,  there  will  be  a 
considerable  drop  in  the  profits  as  compared  with  the  pre- 
ceding year  on  the  same  amount  of  business  done — a  drop 
which  the  management  as  a  rule  will  be  unable  to  account 
for  until  an  investigation  discloses  the  true  cause;  viz.,  the 
cessation  of  the  annual  increase  in  materials  ^nd  products 
on  hand.  On  the  other  hand,  if  the  stocks  be  conservatively 
valued  considerably  below  cost,  the  profits  of  a  year  in 
which  a  small  quantity  of  goods  is  carried  over  at  the  close 
of  the  year  in  comparison  with  the  beginning,  will  be  in- 
flated as  compared  with  a  succeeding  year,  when  an  opposite 
condition  prevailed,  although  the  sales  and  profit  thereon 
may  have  been  the  same  in  both  years;  thus  entirely  up- 
setting all  the  calculations  and  estimates  of  the  managers. 


96      ACCOUNTING    PRACTICE    AND    PROCEDURE 

Essentials  for  Ascertaining  Correct  Profits 

The  essentials  for  ascertaining  correct  profits  so  far  as 
stocks  on  hand  are  concerned  are : 

(a)  An  accurate  enumeration  of  the  quantities  on  hand. 

(b)  An  accurate  ascertainment  of  the  actual  cost  of  the 

different  manufactured  articles,  either  completed 
or  in  progress. 

(c)  Accurate  clerical  work  in  calculating  from  (a)  and 

(b)   the  money  values. 

(d)  A  specific  reduction  in  the  prices  of  raw  materials 

and  manufactured  products  of  the  amount  by 
which  the  market  valuations  at  the  close  of  the 
fiscal  period  fell  short  of  the  cost. 

(e)  A  proper  provision  for  all  stock  which  is  old  or  de- 

preciated or  for  any  reason  likely  to  be  unsale- 
able. 
The  more  exactly  these  different  elements  are  ascer- 
tained, the  more  accurate  will  be  the  resulting  statements  of 
profits,  and  if  the  special  reserves  under  (d)  and  (e)  be 
made  separately,  it  will  be  an  easy  matter  usefully  to  com- 
pare one  period  with  another. 

Taking  the  Inventory 

An  accurate  enumeration  of  quantities  on  hand  is  the 
most  important  of  these  elements,  and  is  frequently  a  mat- 
ter of  much  clifficulty  by  reason  of  the  necessity  of  making 
it  as  of  a  fixed  common  date  for  the  whole  stock.  Where  a 
plant  can  be  closed  down  for  such  period  as  is  necessary  to 
take  the  inventory,  this  difficulty  is  largely  eliminated ;  and 
it  is  entirely  eliminated  where  running  book  inventories  are 
maintained,  which  can  be  checked  up  with  and  adjusted  to 
the  actual  quantity  on  hand  at  any  time,  within  say  twelve 
months,  that  the  stock  of  each  class  is  lowest. 

In  taking  an  actual  count  as  of  a  particular  date  it  is  as 


BALANCE     SHEET     ASSETS  97 

a  rule  impossible  to  make  the  count  on  that  day,  and  the  work 
must  extend  over  a  longer  period.  For  this  purpose  it  is 
necessary  to  keep  careful  record  of  everything  coming  in  or 
going  out  from  each  class  of  commodity  from  the  time  it  is 
counted  until  the  final  inventory  date  inclusive.  It  is  also 
necessary  to  note  on  the  original  sheets  any  old,  obsolete  or 
damaged  stock  upon  which  reduced  values  should  be  placed. 
The  ease  and  accuracy  with  which  such  a  count  can  be  made, 
will  depend  greatly  upon  the  laying  out  of  a  systematic  plan 
beforehand  by  which  duplication  can  be  prevented ;  incoming 
stock  segregated  until  the  count  is  completed ;  and  outgoing 
stock  selected  as  far  as  possible  from  that  which  has  not  yet 
been  enumerated.  Furthermore,  the  enumeration  will  be 
much  easier  in  well-ordered  stockrooms  than  in  those  in 
which  no  method  prevails;  and  much  time  at  stocktaking 
periods  can  be  saved  by  arranging  the  storerooms  with  this 
among  other  objects  in  view. 

When  all  possible  counting  and  weighing  has  been  done 
there  will  frequently  remain  certain  important  classes  which 
can  only  be  ascertained  on  an  estimated  basis,  and  for  which ,- 
therefore,  it  is  desirable  that  book  inventories  be  kept  even 
if  these  are  not  a  part  of  the  regular  system  of  accounting. 
The  quantities  of  bulk  material  such  as  ore,  coal,  coke,  pig 
iron,  logs  and  similar  articles  are  always  difficult  of  ascer- 
tainment as  they  are  usually  from  their  nature  stored  in 
irregular  piles,  the  apparent  contents  of  which  will  be 
affected  by  moisture  or  by  irregularities  in  or  sinking  of  the 
ground  surface  upon  which  they  are  stored.  Measurements  fu- 
made under  such  conditions  can  hardly  be  more  than  an 
approximation  to  the  true  figure ;  although  a  sufficient  degree 
of  accuracy  may  be  generally  obtained  if  the  estimates  are 
made  by  two  qualified  persons  independently  of  each  other. 
It  is  important  too  that  a  limit  should  be  placed  upon  the  size 
or  extent  of  the  piles  in  which  bulk  materials  are  stored,  so 


98      ACCOUNTING    PRACTICE    AND    PROCEDURE 

that  by  keeping  even  a  rough  account  of  the  quantities  put 
in  and  taken  out  from  the  time  the  pile  is  started  until  it  is 
completely  used  up,  a  check  can  be  had  upon  the  accuracy  of 
the  quantities  at  comparatively  short  intervals ;  and  the  piles 
should  not  be  too  large,  so  that  each  may  be  worked  out 
within  some  reasonable  period. 

The  enumeration  and  valuation  of  unsawn  logs  present 
peculiarly  difficult  problems  when,  as  is  usual,  they  are 
floated  down  rivers  or  waterways  to  their  destination  at 
saw  mills,  pulp  mills  or  storage  points.  The  cut  of  a  season 
in  the  woods  can  be  measured  with  a  fair  degree  of  accuracy, 
particularly  as  the  payments  made  for  labor  are  often  based 
on  these  measurements.  It  is  seldom,  however,  that  the 
whole  cut  of  a  season  will  run  down  the  waterways  during 
the  period  of  high  water,  much  remaining  to  come  down  in 
the  following  season  from  the  cut  of  which  it  cannot  be  dis- 
tinguished.  There  will  also  be  some  loss  of  logs  which  may 
be  held  up  by  obstructions  at  various  points  until  they  are 
partially  or  wholly  damaged ;  and  the  breaking  of  a  boom 
at  a  storage  point  due  to  flood  or  other  causes,  or  the 
stranding  of  logs  in  inaccessible  positions  at  periods  of  un- 
usually high  water  may  entail  at  times  even  serious  losses; 
and  to  these  may  be  added  losses  by  fires  in  the  forests  after 
logs  are  cut  and  stacked.  It  is  usual  at  intervals  of  several 
years  to  have  what  is  known  as  a  clean-up  in  the  waterways, 
when  a  good  many  supposedly  lost  logs  may  be  recovered,  but 
even  allowing  for  this,  losses  must  occur  which  are  difficult 
to  estimate  and  can  only  be  provided  for  by  reserves  based 
on  experience  in  other  cases.  There  is  a  natural  tendency 
on  the  part  of  operating  officials  to  underestimate  such  pos- 
sible losses  which  in  itself  renders  the  creation  of  adequate 
reserves  not  only  more  difficult  but  more  important. 

Work  in   progress   is   another  class   involving   special 
difficulties  which  can  often  only  be  satisfactorily  overcome 


BALANCE     SHEET     ASSETS  99 

by  keeping  approximate  accounts  of  the  labor  and  material 
put  in,  and  the  finished  products  taken  out,  taking  care  at 
the  sarne  time  that  a  proper  allowance  is  made  for  wasted 
material,  of  which  there  must  necessarily  be  some 
percentage. 

Scrap  material  in  theory  can  be  weighed,  but  its  quantity, 
weight  and  shape  frequently  preclude  any  such  course  and  no 
really  satisfactory  method  has  yet  been  devised  for  arriving 
at  the  quantity  on  hand  with  any  close  degree  of  accuracy. 
The  best  method  is  to  keep  a  book  inventory  of  the  scrap 
weighed  out  from  the  shop  into  the  yard ;  to  store  the  same 
in  separate  piles  or  in  separate  locations,  and  weigh  out 
deliveries;  so,  by  keeping  a  separate  book  account  of  each 
pile,  to  prove  the  quantities  up  as  they  are  exhausted.  A 
liberal  deduction  is  required  in  any  estimate  of  scrap  stock 
to  provide  against  possible  overvaluation. 

Cost  Accounting 

The  importance  of  a  valuation  at  cost  emphasizes  the 
necessity  of  such  a  system  of  accounting  as  will  enable  cost 
to  be  accurately  ascertained  and  makes  desirable  at  this  point 
an  outline  of  the  principal  points  involved.  The  theory  of 
cost  accounting,  which  is  fully  discussed  in  Chapter  IX, 
is  merely  an  elaboration  of  ordinary  bookkeeping,  and  its 
difficulty  lies  almost  entirely  in  a  correct  ascertainment  of 
the  elements  that  enter  into  it.  There  is  no  theoretical  diffi- 
culty in  keeping  a  record  of  the  number  of  hours,  human  and 
machine,  and  the  quantity  of  material  that  enter  into  any 
process  of  manufacture ;  but  practical  difficulties  arise  from 
the  large  number  of  items  involved,  the  chances  of  error  in 
the  tabulation  of  hours  worked  and  quantities  consumed,  loss 
of  weight  in  process  and  many  other  minor  points,  coupled 
with  the  necessity  of  an  economical  operation  of  the  cost 
accounting  system. 


100    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Even  when  the  actual  quantities  of  material  and  number 
of  hours  worked  in  the  direct  processes  of  manufacture  are 
known,  there  are  many  other  expenses  which  cannot  be 
allocated  to  any  particular  operation  and  yet  are  essential 
to  all  operations,  such  as  power,  light,  heat,  taxes,  insurance, 
clerical  and  general  supervision;  and  the  determination  of 
the  proportion  in  which  these  expenses  should  be  distributed 
to  the  different  processes  is  a  problem  which  is  incapable  of 
an  absolutely  accurate  solution.  Almost  every  business 
differs  in  this  respect,  and  various  methods  are  adopted  for 
arriving  at  an  approximation  to  the  result.  The  essentials 
are  that  the  total  amount  absorbed  in  the  cost  over  any 
period  should  not  materially  exceed,  nor  fall  short  of,  the 
total  of  all  such  expenses  incurred  during  that  period;  and 
that  the  method  of  distribution,  once  settled,  should  be  con- 
sistently maintained  regardless  of  the  effect  on  the  opera- 
tions, unless  and  until  a  more  accurate  method  can  be  sub- 
stituted therefor. 

Distribution  of  Expense  Burden 

The  following  are  some  of  the  methods  most  often  used 
for  apportioning  these  charges,  which  are  generally  described 
as  "overhead  expense,"  "burden"  or  "dead  expense." 

(a)  They  are  apportioned  each  month  in  total  over  all 
the  direct  cost  accounts,  either  in  proportion  to  labor,  or  to 
labor  and  material,  or  to  material  only,  or  partly  on  one  of 
those  bases  and  partly  on  another,  according  to  the  nature  of 
the  expense. 

One  objection  to  this  method  is  that  departments  that  are 
more  fully  occupied  are  made  to  bear  the  expense  of  those 
not  fully  occupied  or  even  not  occupied  at  all,  thus  producing 
considerable  inequalities  between  the  results  of  any  one 
department  in  different  periods;  and  perhaps  even  showing 
losses  on  some  one  department  which  are  usually  attributable 


BALANCE     SHEET    ASSETS  lOI 

not  to  that  department  at  all,  but  to  the  partial  or  total 
closing-  down  of  some  other  one. 

(b)  They  are  carefully  allocated  in  the  first  instance  be- 
tween separate  departments  on  the  basis  of  one  or  more  of  the 
factors  of  space  occupied,  normal  possible  output,  or  normal 
quantity  of  power  required,  and  then  in  each  department 
prorated  in  proportion  to  labor  and  material  costs  as  in  (a). 

This  is  a  more  accurate  method  in  theory,  and  eliminates 
the  error  of  charging  one  department  with  the  results  of 
slackness  of  work  in  others.  It  is  more  difficult  to  carry  out 
in  practice,  and  involves  a  good  many  assumptions  in  obtain- 
ing the  division  between  departments.  It  is  also  still  open  to 
the  objection  that  there  is  considerable  fluctuation  in  the 
incidence  of  overhead  expense  between  busy  and  slack 
periods,  and  costs  are  shown  as  higher  in  the  latter  than  in 
the  former, 

(c)  In  machine  shops  the  overhead  expense  is  frequently 
apportioned  over  machine  hours  worked,  each  machine 
having  a  rating  ascertained  by  experiment. 

(d)  As  a  result  of  careful  estimates,  certain  fixed  per- 
centage rates  on  labor,  or  material,  or  both,  based  on  a 
normal  average  output,  are  adopted. 

In  both  of  the  last  two  methods  the  rates  are  at  first 
independent  of  the  actual  expenses.  The  amounts  added  to 
costs  are  credited  to  certain  accounts  to  which  all  expenses 
covered  by  that  rate  are  charged,  and  the  two  should  on  an 
average  approximately  agree.  If  the  difference  accumulates, 
it  is  due  either  to  errors  in  the  rates  which  would  have  to 
be  adjusted,  or  to  an  extra  busy  or  extra  slack  period  of 
operations.  Such  contingencies  should  be  provided  for  by 
including  in  the  burden  a  reserve  based  on  experience,  which, 
with  the  addition  of  the  excess  provision  accumulating  in 
busy  periods,  would  suffice  to  meet  the  deficits  due  to  slack 


I02    ACCOUNTING    PRACTICE    AND    PROCEDURE 

periods.  These  methods  would  appear  to  be  better  in  every 
way  than  the  first  two,  as  discrepancies  in  costs  due  to  cir- 
cumstances not  in  fact  pertinent  to  the  output  are  avoided 
and  periods  varying  from  the  normal  are  regularly  provided 
for. 

All  the  methods  here  outlined  involve  much  thought  and 
skill  in  determining  the  proper  classification  of  expense 
accounts  and  their  effect  on  various  parts  of  the  operations. 

Allocation  of  Expenses 

A  further  difficulty  lies  in  the  fact  that  it  is  not  always 
possible  to  draw  a  hard  and  fast  dividing  line  between  ex- 
penses directly  chargeable  to  manufacture  and  expenses  not 
so  chargeable.  There  are  expenses  of  supervision  and  book- 
keeping, and  general  expenses,  which  cannot  be  specifically 
divided  between  the  different  departments  of  manufacture, 
sale,  collection,  and  general  management.  The  expense  of  the 
first  department  only  would  enter  into  the  cost  of  manufac- 
ture, while  that  of  the  second  and  third  would  be  chargeable 
only  against  the  gross  profits  resulting  from  the  sales,  and 
that  of  the  fourth  would  be  chargeable  against  the  profits  of 
the  whole  undertaking. 

A  thorough  understanding  of  the  business,  a  careful 
analysis  and  apportionment  of  the  duties  of  individuals,  and 
a  general  knowledge  of  the  manner  in  which  each  item  of 
expense  affects  the  different  departments  are  necessary  to 
arrive  at  even  an  approximate  division,  and  at  best  the  basis 
adopted  is  somewhat  arbitrary. 

Selling  Expenses  as  Part  of  Manufacturing  Cost 

It  is  legitimate,  though  not  usual,  to  take  into  account 
a  proportion  of  the  selling  expenses  as  part  of  the  value  of 
the  stock  on  hand  when  those  goods  are  sold  in  advance 
of  manufacture.  Even  then  there  always  remain  expenses 
of  delivery  and  for  miscellaneous  purposes  to  be  incurred 


BALANCE     SHEET     ASSETS  I03 

on  or  before  completion,  and  it  is  generally  considered  more 
conservative  to  allow  the  profits  realized  on  goods  sold  and 
delivered  to  pay  for  all  selling  expenses,  and  to  ignore  those 
that  may  perhaps  apply  to  deliveries  not  made.  There  are, 
however,  exceptions  to  this  usually  salutary  rule  which 
depend  on  special  conditions  and  must  be  considered  each 
on  its  merits  as  they  arise.  When  it  can  be  clearly  seen  that 
expenses  not  appertaining  to  cost  of  manufacture  have  been 
incurred  specifically  upon  certain  classes  of  goods  which  for 
good  and  proper  reasons  have  not  been  delivered,  no  valid 
objection  can  be  raised  to  carrying  forward  these  expenses 
as  part  of  the  cost  for  inventory  purposes. 

Status  of  Interest 

The  question  continually  arises  whether  interest  in  any 
form  should  be  considered  as  part  of  the  cost  of  manufacture. 
It  is  true  that  manufacture  takes  time  and  involves  the  lock- 
up of  money  for  certain  periods,  and  that  this  money  for 
those  periods  should  be  earning  interest.  On  the  other  hand, 
it  must  be  remembered  that  interest  is  only  one  form  of 
profit,  that  the  object  of  any  business  is  to  earn  profit,  and 
that  each  operation,  as  well  as  each  department,  is  only  one 
in  a  series,  none  of  which  is  complete  in  itself,  and  the 
whole  of  which  is  necessary  to  the  complete  process  of 
manufacture  and  sale  out  of  which  alone  can  any  profit  be 
earned.  To  charge  interest  into  costs  is  in  effect  to  add  to 
those  costs  a  certain  amount  of  profit  before  it  has  been 
made,  and  is,  therefore,  against  sound  commercial  and 
accounting  principles.  It  is  sometimes  claimed  that  as 
interest  on  loan  capital,  from  the  point  of  view  of  the  owner 
of  the  business,  is  an  expense,  it  therefore  should  be  treated 
as  part  of  the  cost  of  manufacture;  but  this  contention 
loses  sight  of  the  fact  that  such  capital  is  raised  for  the  pur- 
pose of  conducting  the  business,  and  is  remunerated  by  a 


I04    ACCOUNTING    PRACTICE    AND    PROCEDURE 

strictly  defined  share  of  the  profits  earned  in  that  business. 
It  is  true  that  interest  is  usually  payable  whether  there  are 
profits  earned  or  not,  but  it  is  merely  one  of  the  incidental 
conditions  of  the  loan  that  the  lender  is  to  be  paid  his  share 
of  profits  at  regular  dates,  and  frequently  in  advance  of 
any  such  profits  being  earned.  This  subject  is  considered 
at  greater  length  in  Chapter  IX. 

Increasing  Value  of  Seasoning  Material 

There  are,  however,  certain  classes  of  products  in  which 
time  is  a  more  than  usually  direct  part  of  the  essence  of  their 
manufacture  by  reason  of  the  fact  that  the  raw  material  or 
finished  product  must  be  kept  for  a  certain  time  to  season 
before  it  is  available  for  sale.  If  such  material  or  products 
were  purchased  in  a  seasoned  condition  a  higher  price  would 
undoubtedly  be  paid,  and  it  is  difficult  to  resist  a  claim  that 
the  interest  cost  representing  the  time  occupied  in  seasoning 
should  be  considered  as  part  of  the  cost  of  manufacture  for 
inventory  purposes. 

This  principle  is,  however,  one  which,  if  adopted  in  prac- 
tice, should  be  employed  only  with  the  utmost  caution,  for 
the  reason  that  any  subsequent  fluctuations  tending  to  large 
reductions  in  selling  prices  might  have  a  much  more  serious 
effect  if  profits  had  been  previously  paid  away  on  the  basis 
of  inventories  valued  at  a  figure  including  such  interest; 
whereas,  in  the  contrary  case,  nothing  more  serious  can  occur 
than  the  postponement  of  a  declaration  of  profits  until  the 
carrying  charge  represented  by  this  interest  has  been  recov- 
ered by  a  sale  of  the  products.  It  may  frequently  happen 
in  practice  that  the  carrying  charge  is  in  the  form  of  interest 
on  loans  made  for  the  purpose  of  carrying  stocks  of  materials 
during  the  seasoning  period,  and  in  such  cases  the  interest 
actually  paid  is  a  good  measure  of  the  amount  to  be  carried 
forward  as  an  asset;  where  no  money,  or  a  part  only,  is  so 


BALANCE     SHEET     ASSETS  105 

borrowed  the  most  conservative  practice  would  be  against 
making  any  addition,  although  when  the  interests  of  present 
shareholders  would  be  prejudicially  affected  for  the  benefit 
of  the  future,  no  serious  objection  could  be  taken  to  a  rea- 
sonable addition  for  carrying  charges,  the  credit  for  which 
would  be  made  to  the  profits  of  the  period  under  considera- 
tion. It  should  be  noted  that  in  a  steady  regular  business  it 
is  only  on  increasing  quantities  of  seasoning  materials  that 
an  addition  for  carrying  charges  will  affect  profits,  and  in 
older  countries,  where  the  tendency  is  toward  a  steady 
average  business  over  a  long  series  of  years,  this  question 
is  of  little  or  no  importance  and  such  additions  are  in  conse- 
quence usually  omitted.  In  a  comparatively  new  country, 
such  as  the  United  States,  the  tendency  of  business  is  toward 
progressive  increase,  and  the  question  assumes  greater  im- 
portance often  by  reason  of  the  desire  to  show  sufficiently 
large  profits  to  attract  the  further  capital  necessary  for  a 
rapid  increase  in  the  volume  of  trade.  It  is  just  for  this 
reason  that  the  utmost  caution  is  necessary  in  the  application 
of  the  principle.  If  business  were  increasing  at  a  moderate 
rate  the  increasing  profits  might  be  sufficient  to  provide  the 
increased  working  capital  necessary,  and  nothing  would  be 
gained  by  inflating  inventory  values  and  profits  by  the 
addition  of  carrying  charges  which  would  only  remain  in  the 
business;  nor  on  the  contrary  could  the  addition  of  these 
charges  have  any  bad  effect.  Where  the  additional  capital 
required  is  raised  by  loan  or  fresh  issues  of  stock,  and  the 
carrying  charges  are  added  and  employed  to  increase  divi- 
dends, elements  of  danger  are  present,  and  a  too  general 
application  of  the  principle  might  conduce  to  excessive  in- 
ventories and  to  speculation  in  raw  materials  which  would 
show  increasing  profits  arising  out  of  inflated  inventories 
and  eventually,  if  the  speculation  turned  out  badly,  would 
cause  large  losses. 


Io6    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Treatment  of  Carrying  Charges 

It  is  sometimes  suggested  that  this  same  principle  of 
adding  carrying  charges  should  be  employed  where  large 
stocks  of  material  not  requiring  a  seasoning  period  are 
accumulated  for  any  purpose,  speculative  or  otherwise. 
This,  however,  is  an  entire  misapplication  of  the  principle 
as  no  question  of  cost  of  manufacture  is  involved.  The 
purchases  are  made  with  the  idea  of  ultimate  profit  by  their 
resale  in  the  same  or  a  converted  state,  and  on  such  resale 
a  profit  or  a  loss  is  made.  To  make  additions  for  carrying 
charges  in  such  a  case  is  merely  to  anticipate  profit  which 
may  or  may  not  be  earned,  and  is  just  as  incorrect  as  to 
anticipate  profit  under  any  other  conditions. 

Where  it  has  been  decided  to  treat  as  an  asset  any 
carrying  charges,  it  is  on  the  whole  preferable  that  in  the 
balance  sheet  these  charges  should  be  included  not  in  the 
caption  of  "Inventories"  as  part  of  cost,  but  under  the 
classification  of  "Working  Assets"  as  a  "Deferred  Charge" 
to  be  met  out  of  subsequent  profits.  In  this  way  more  atten- 
tion is  called  to  the  policy  adopted,  and  any  undue  increase 
in  the  amount  is  more  likely  to  be  disclosed. 

Profits  on  Work  in  Progress 

The  extent  to  which  it  is  permissible  to  anticipate  profits 
on  work  in  progress  forms  another  important  consideration 
in  the  valuation  of  inventories.  When  work  is  being  carried 
out  under  definite  contracts  extending  over  long  periods  of 
time,  and  when  it  may  perhaps  reasonably  be  contended  that 
at  any  rate  some  portion  of  the  profit  is  earned  at  the  time 
when  the  work  is  performed,  it  is  quite  a  frequent  practice  to 
estimate  and  bring  into  account  some  portion  of  the  profit 
proportionate  to  the  cost  for  any  period,  and  there  does  not 
appear  to  be  any  objection  in  principle  to  the  adoption  of 
this  practice.     On  the  other  hand,  it  is  undoubtedly  more 


BALANCE     SHEET    ASSETS  107 

conservative  not  to  take  credit  for  any  such  profit  until  the 
whole  contract  is  completed.  An  added  reason  for  the  latter 
course  is  that  unforeseen  contingencies  are  continually 
arising  during  the  progress  of  the  work,  with  the  result  that 
what  was  originally  expected  to  realize  a  profit  may  in  the 
end  result  in  a  loss.  It  is  true  that  the  more  conservative 
course  may  cause  large  inequalities  in  the  amount  of  profit 
shown  for  successive  periods ;  but  if  the  accounts  are  stated 
on  a  basis  of  total  work  completed  less  cost  thereof,  the 
reasons  for  the  fluctuations,  as  well  as  the  advantages  of 
more  rapid  completion,  are  apparent. 

Conditions  may  exist  which  would  render  such  conser- 
vative treatment  inequitable  to  certain  classes  of  stock- 
holders, as  for  instance  when  part  of  the  capital  stock  is  of 
the  non-cumulative  preferred  class,  the  dividends  upon  which 
are  dependent  entirely  on  the  profits  of  each  year.  In  deter- 
mining profits,  due  regard  must  be  had  to  such  interests  so 
that  no  substantial  injustice  may  be  done  them. 

If,  however,  estimates  of  profits  on  pending  contracts  are 
to  be  taken  into  account,  it  is  of  the  utmost  importance  that 
such  should  be  made  on  an  ultra-conservative  basis,  and 
further,  that  estimated  losses  should  also  be  fully  provided 
for.  Even  where  it  is  not  the  practice  to  take  up  any  part 
of  the  profits  on  contracts  not  completed,  it  may  be  necessary 
to  provide  for  losses  of  an  exceptional  character  likely  to 
arise  on  similar  contracts;  neglect  to  take  this  precaution 
may  easily  result  in  subsequent  disaster  by  the  distribution 
over  a  series  of  years  of  dividends  in  excess  of  profits. 

While,  therefore,  under  certain  conditions  no  objection 
can  be  taken  to  the  inclusion  in  a  profit  and  loss  account  of 
profits  on  work  in  progress,  a  sound  conservative  policy 
would  be  against  such  a  practice  unless  in  very  exceptional 
cases  on  the  ground: 

(i)  That  the  best  estimates  are  misleading. 


Io8    ACCOUNTING    PRACTICE    AND    PROCEDURE 

(2)  That  such  profits  are  not  in  most  cases  yet  realized 

and  cannot  therefore  be  employed  in  payment 
of  dividends,  except  by  a  corresponding  increase 
in  working  capital. 

(3)  That   the   asset   af  work   in   progress   is   unduly 

swelled  by  an  addition  that  may  perhaps  never 
be  realized. 

Reserves  for  Contingencies 

Of  somewhat  more  importance  than  the  question  of 
profits  and  losses  on  contracts,  is  that  of  reserves  for  future 
expenses  on  contracts  which  are  apparently  completed. 
These  expenses  may  represent  general  supervision  during 
a  certain  period  after  installation ;  claims  for  non-fulfillment 
of  stipulated  provisions,  either  under  guarantees  of  satis- 
factory performance  extending  over  a  definite  period  or 
otherwise ;  or  other  small  adjustments ;  and  on  the  other  side 
there  may  be  bonuses  due  after  a  certain  period  of  satisfac- 
tory working.  The  only  really  safe  way  to  provide  for  such 
expenses  and  claims  is  by  the  creation  out  of  profits  of  a 
contingency  reserve,  either  by  charging  to  each  contract  a 
certain  percentage,  or  by  setting  up  specific  reserves  based 
on  an  examination  of  the  results  of  similar  contracts.  Re- 
serves so  made  should  be  carried  as  a  current  liability  of  the 
business,  and  not  as  a  free  reserve.  Bonuses  should  not  be 
taken  credit  for  until  actually  earned  by  the  completion  of 
the  specified  conditions. 

Book  Inventories 

The  accuracy  of  the  periodical  statements  of  earnings  of 
manufacturing  concerns  depends  to  a  large  extent  upon  that 
of  the  inventory,  both  as  to  quantity  and  value.  Without 
correct  information  as  to  the  value  of  the  stocks,  it  is  im- 
possible to  ascertain  the  earnings;  and  yet  the  delay  and 


BALANCE     SHEET    ASSETS  109 

expense  involved  prohibit  the  frequent  taking  of  physical 
inventories,  which  in  most  cases  would  necessitate  the  clos- 
ing of  the  works  for  a  period  of  some  weeks,  and  a  conse- 
quent loss  of  business.  Up  to  comparatively  recent  times, 
it  was  the  practice  to  take  such  inventories  once  a  year, 
closing  the  works  at  a  suitable  date  for  that  purpose ;  but  the 
demand  for  more  frequent  statements  of  earnings  has 
necessitated  some  method  of  arriving  at  the  approximate 
value  of  stocks  on  hand  without  the  expense  and  delay  in- 
volved in  a  physical  enumeration  thereof.  There  has  by 
degrees  been  evolved  a  system  of  book  records,  continuous 
throughout  the  year,  of  materials,  work  in  process,  and 
manufactured  products,  which  enables  a  book  inventory  to 
be  obtained  each  month  so  accurately  that  the  closing  down 
of  large  works  for  this  purpose  is  now  very  unusual. 

These  book  records  consist  of  accounts,  both  of  quantity 
and  value,  kept  for  each  class  of  material  and  manufactured 
product,  based  on  accurate  returns  of  the  quantities  received 
and  consumed  and  of  the  labor  expended,  and  balancing  with 
the  principal  books  so  far  as  money  values  are  concerned. 
The  money  value  of  labor  worked  is  obtained  from  the 
analyzed  pay-rolls,  frequently  based  on  a  large  number  of 
slips  made  up  either  by  the  individual  workmen  or  by  the 
foremen.  These  slips  form  the  basis  of  the  entries  to  the 
debit  of  different  order  numbers  in  the  cost  records,  and  the 
total  of  all  such  debits  is  balanced  with  the  factory  pay-roll. 
The  quantity  and  values  of  materials  received  are  obtained 
from  the  original  bills,  analyzed,  and  charged  to  the  respec- 
tive stores  accounts.  The  production  records  are  thus  ob- 
tained from  a  very  large  number  of  small  individual  records 
of  time  and  material  expended  in  the  various  productive 
operations,  which  are  collected,  classified  and  summarized, 
and  charged  and  credited  to  the  Production,  and  Material, 
and  Labor  accounts  respectively  on  ordinary  bookkeeping 


no  ACCOUNTING  PRACTICE  AND  PROCEDURE 

principles ;  with  the  result  that  the  balance  left  on  any  mate- 
rial account  should  represent  the  stock  on  hand,  and  the 
balance  on  any  production  account,  after  crediting  the 
finished  product,  should  represent  the  cost  of  the  completed 
or  partially  completed  work. 

It  might  be  supposed  that  reports  made  up  by  working 
men,  often  illiterate,  and  with  no  idea  of  the  purpose  for 
which  the  records  are  required,  would  be  so  inaccurate  as  to 
be  useless  for  practical  purposes,  but  a  little  consideration 
will  show  that,  apart  from  any  deliberate  attempt  at  falsifi- 
cation, errors  would  tend  to  offset  each  other,  and  the  re- 
sulting difference  should  be  comparatively  small  in  propor- 
tion to  the  totals  involved.  In  fact,  as  in  so  many  other 
problems  of  everyday  life,  the  principle  of  averages  obtains, 
and  if  ordinary  precautions  are  adopted,  the  final  results  are 
as  a  rule  found  to  be  surprisingly  accurate. 

Physical  Verification  of  Book  Inventories 

As  any  particular  material  in  stock  is  reduced  to  a  low 
point,  a  physical  inventory  thereof  is  easily  taken,  and  any 
discrepancies  found  on  a  comparison  with  the  book  records 
are  adjusted.  In  this  way  the  whole  of  the  material  accounts 
are  verified  physically  at  least  once  in  the  course  of  each 
year  without  any  interruption  to  the  ordinary  business.  In 
the  case  of  large  bulk  stocks,  such  as  ore,  pig  iron,  etc., 
already  referred  to,  the  problem  is  a  more  difficult  one,  be- 
cause it  may  be,  and  frequently  is,  a  period  of  some  years 
before  the  piles  in  which  these  articles  are  kept  are  reduced 
to  a  sufficiently  small  quantity  to  enable  any  accurate  in- 
ventory to  be  taken.  In  these  cases,  however,  it  is  usual  to 
allow  a  small  extra  percentage  on  the  consumption  to  cover 
waste  or  loss,  with  the  result  that  in  practice  the  physical 
test  more  often  shows  an  excess  over  the  book  record  than 
otherwise. 


BALANCE     SHEET     ASSETS  III 

Material  in  process  of  manufacture  can  often  only  be 
physically  verified  when  the  process  is  entirely  completed, 
which  may  be  after  weeks,  months,  or,  in  large  contracts, 
even  years.  But  by  a  subdivision  of  accounts  into  different 
processes  and  small  units,  the  book  records  are  being  con- 
tinually verified  at  each  end ;  that  is,  by  the  labor  and  material 
which  is  known  to  have  gone  in,  and  by  the  processed  or 
finished  product  which  is  known  to  have  come  out,  and 
provided  that  the  values  at  which  the  material  is  charged 
in,  and  the  product  credited  out,  are  approximately  in  accord- 
ance with  the  facts,  the  resulting  balance  of  work  still  in 
progress  must  be  substantially  correct  also. 

Monthly  Charges 

In  all  these  accounts  the  month  is  the  unit  of  time  most 
usually  adopted,  and  the  value  at  which  a  month's  consump- 
tion of  material  should  be  charged  out  is  of  some  import- 
ance. The  safest  rule  is  to  assume  that  the  stocks  on  hand 
at  the  beginning  of  the  month  are  first  exhausted,  and  to 
value  the  stock  at  the  close  at  the  average  cost  of  the 
month,  except  where  such  stock  is  greater  than  the  total 
receipts  for  the  month,  in  which  case  the  excess  should  be 
taken  at  the  price  at  which  the  commencing  stock  was 
valued.  Having  thus  obtained  the  value  of  the  inventory  at 
the  close  of  the  month,  the  consumption  for  the  month  should 
be  credited  to  the  material  account,  and  charged  to  the  proper 
cost  accounts,  at  a  figure  which  will  leave  a  balance  on  the 
material  account  equal  to  such  inventory  value.  But  this 
rule  requires  to  be  followed  with  care,  because  it  might 
happen,  for  exceptional  reasons,  that  the  cost  for  the  month 
was  either  very  much  above  or  very  much  below  the  average, 
and  in  such  a  case  the  stocks  should  be  adjusted  to  a  more 
normal  valuation. 


112    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Contracts  of  Purchase 

Contracts  of  purchase  made  for  future  delivery  form 
another  class  of  items  that  call  for  consideration  in  con- 
nection with  inventory  valuations.  As  long  as  such  con- 
tracts are  made  in  the  ordinary  course  of  business  for  the 
purpose  of  supplying  its  actual  needs  as  they  accrue,  no 
question  need  be  raised  in  connection  with  a  balance  sheet  as 
of  a  date  prior  to  the  date  of  delivery.     In  many  concerns, 

t  however,  these  future  contracts  form  a  business  in  them- 
selves, being  made  either  as  a  simple  speculation  or  to  pro- 

I  tect  legitimate  dealings  in  a  highly  speculative  market.  Such 
contracts  must  be  taken  into  consideration  in  the  preparation 

!  of  the  balance  sheet,  and  the  losses  shown  by  a  comparison 
between  the  contract  price  and  the  market  price  for  similar 
future  deliveries  at  the  date  of  the  balance  sheet  provided 
for.  The  differences  on  such  contracts  may  amount  to  very 
large  sums,  and  their  omission  from  the  balance  sheet  will 
then  give  a  most  misleading  view  of  the  position.  This  con- 
dition usually  applies  only  to  those  classes  of  commodities 
which  are  dealt  in  on  produce  exchanges  and  in  which  there 
is  a  free  market  for  contracts  in  future  deliveries;  and  for 
the  proper  ascertainment  of  the  profits  or  losses  a  thorough 
knowledge  of  the  methods  and  rules  of  the  exchanges  is 
essential. 

Inventory  Credits  and  Liabilities 

In  close  connection  with  the  subject  of.  inventory  valua- 
tion is  that  of  proper  provision  for  all  liabilities  in  respect  of 
the  commodities  included  in  the  inventory,  and  on  the  other 
hand  for  the  proper  inclusion  in  the  inventory  of  all  com- 
modities for  which  liabilities  have  been  taken  up.  Commodi- 
ties may  frequently  have  been  delivered  for  which  no  bills 
have  yet  been  rendered ;  and  on  the  other  hand  they  may  be 
in  transit  from  the  point  of  shipment  and  only  received  sub- 


BALANCE     SHEET    ASSETS  1 13 

sequently  to  the  enumeration,  while  the  bills,  by  the  te^ms  of 
shipment  or  to  take  advantage  of  discount,  may  have  been 
rendered  and  paid  prior  to  that  date. 

A  similar  condition  may  arise  also  with  sales  which  may 
for  one  reason  or  another  have  been  billed  to  the  customer 
while  the  goods  are  still  on  hand. 

Any  good  accounting  system  should  provide  for  such 
conditions  automatically;  but  good  systems  are  more  rare 
than  they  should  be,  and  serious  errors  in  balance  sheets  and 
profits  may  easily  arise  through  neglect  of  proper  precau- 
tions to  guard  against  such  omissions. 

Accuracy  of  Inventory  Valuations 

Enough  has  been  said  to  show  the  vital  importance  to  a 
correct  balance  sheet  of  accurate  inventory  valuations.  Prac- 
tical experience  has  reduced  to  a  comparatively  simple 
routine  the  methods  for  guarding  against  possibilities  of 
error,  and  the  serious  ones  that  occur  are  generally  due  either 
to  ignorance  of  both  principles  and  routine  on  the  part  of 
those  concerned,  or  to  deliberate  fraud  in  the  certification  of 
quantities  or  values. 

There  are,  however,  other  causes  of  shrinkage  in  value 
which  it  is  more  difficult  to  provide  for.  A  fall  in  market 
prices,  a  sudden  cessation  in  the  demand  owing  to  panic, 
war,  or  other  disturbing  causes  may  at  any  time  quite  un- 
expectedly either  entirely  prevent  the  realization  of  stocks 
on  hand,  or  so  depress  prices  as  to  render  such  realization 
only  possible  at  a  sacrifice.  For  such  reasons  as  these  it  is 
prudent  to  build  up  a  reasonable  reserve  in  good  times  to 
provide  for  contingencies  that  may  arise  in  less  prosperous 
ones.  Such  reserves,  while  deductible  from  the  inventory 
in  the  balance  sheet,  should  be  quite  separate  from  and  inde- 
pendent of  the  inventory  itself,  artd  should  not  be  made  up 


114    ACCOUNTING    PRACTICE    AND    PROCEDURE 

by  reducing-  the  valuation  or  prices  of  specific  parts  of  the 
stocks  on  hand. 

(2)  Accounts  and  Bills  Receivable 

The  items  appearing  under  this  heading  should  all  be 
liquid  and  current,  and  in  the  aggregate  realizable  at  their 
total  face  value  within  a  definite  term,  dependent  on  the 
nature  of  the  business  carried  on.    It  follows,  therefore,  that 
full  provision  should  be  made  for  all  accounts  which  are  or 
may  become  bad  or  doubtful,  and  for  all  losses  that  can  rea- 
sonably be  anticipated  from  fluctuations  in  foreign  exchange 
when  the  debts  are  contracted  abroad.     Accounts  in  the 
nature  of  advances  to  enable  other  parties  to  carry  on  their 
business — which  are  not  therefore  currently  recoverable — 
should  not  be  included  under  this  heading,  but  under  that 
of  permanent  investments,  and  similarly  advances  made  for 
business  purposes  and  forming  part  of  the  working  assets, 
such  as  balances  on  working  funds  in  hands  of  officials  or 
agents,  should  be  eliminated  from  accounts  receivable  and 
included  under  the  proper  subheading  of  working  assets. 
The  idea  underlying  this  caption  is  that  it  represents  a  class 
of  asset  that  is  being  continually  day  by  day  and  in  the 
ordinary  course  of  business  converted  into  some  more  liquid 
and  available  asset  such  as  cash,  and  may  therefore  safely 
be  counted  on  as  a  source  from  which  corresponding  liabili- 
ties may  be  met  as  they  mature.    The  term  within  which  pay- 
ment is  to  be  made  will,  of  course,  vary  with  the  nature  of 
the  business.     Collections  may  be  made,  according  to  the 
custom  of  the  particular  trade,  monthly  or  quarterly,  and 
amounts  not  so  collected  may  be  considered  overdue  and  sub- 
ject to  necessary  reserves,  or,  in  extreme  cases,  such  as  notes 
taken  from  farmers  by  agricultural  machine  manufacturers, 
the  term  of  payment  may  normally  extend  over  several  years 
before  such  conditions  arise.    In  determining,  therefore,  the 


BALANCE     SHEET    ASSETS  II5 

class  of  accounts  which  may  be  properly  included  under  the 
present  caption,  it  is  essential  that  full  consideration  be 
given  to  the  nature  of  the  business. 

Present  Values  of  Accounts  and  Bills  Receivable 

Bills  receivable  will  not  be  due  until  a  date  subsequent 
to  that  as  of  which  the  balance  sheet  is  prepared,  and  should 
therefore  be  reduced  to  a  present  value.  If  the  bill  is  for  a 
fixed  sum  with  interest,  its  present  value  is  its  face  value. 
Usually,  however,  commercial  bills  are  drawn  for  a  fixed 
sum  payable  at  a  certain  date  without  interest,  and  in  such 
cases  provision  should  be  made  to  reduce  the  face  value  to 
present  value  by  charging  to  Income  and  crediting  an  inter- 
est or  discount  reserve  account  with  the  interest  on  each  bill 
from  the  date  of  the  balance  sheet  to  the  due  date. 

Accounts  receivable  are  often  subject  to  a  discount  for 
cash  in  addition  to  the  trade  discount,  which  latter  is  or 
should  be  always  deducted  when  the  charge  is  made  on  the 
books.  When  this  cash  discount  is  a  material  amount  it 
should  be  provided  for,  being  offset  to  a  certain  extent  by 
similar  discounts  to  be  obtained  on  creditors  accounts.  This 
reserve  is  frequently  considered  to  be  covered  by  that  for 
bad  and  doubtful  accounts,  but  the  point  should  not  be  over- 
looked. 

As  a  rule  there  is  little  expense,  other  than  the  cash  dis- 
counts allowed,  attached  to  the  collection  of  accounts  and 
bills  receivable,  and  it  is  not  customary  to  make  any  provision 
for  such  expense  as  may  be  incurred.  If,  however,  the  cost  of 
collection  is  likely  to  much  exceed  the  normal  amount  that 
would  be  necessary  in,  say,  a  good  wholesale  business,  this 
question  must  be  considered.  In  some  lines  of  business  deal- 
ing with  large  numbers  of  small  customers  over  a  consider- 
able extent  of  territory,  such,  for  instance,  as  harvester 
machine  companies,  fertilizer  companies,  etc.,  the  expense 


Il6    ACCOUNTING    PRACTICE    AND    PROCEDURE 

incurred  before  the  accounts  and  bills  are  finally  collected, 
may  be  considerable.  So  far  as  bills  are  concerned  there  is 
usually  an  asset  of  the  accruing  interest  which  may  only  be 
credited  to  Income  as  received,  and  this  will  to  some  extent 
offset  the  collection  cost. 

Generally  wherever  it  may  appear  that  there  must,  before 
final  collection,  be  a  material  shrinkage  in  the  face  value  of 
accounts  and  bills,  due  to  cost  of  collection,  sufficient  reserve 
should  be  made  by  charges  to  Income  account  each  year  to 
provide  therefor. 

(3)  Investments 

The  classes  of  investments  which  should  be  grouped 
under  this  caption,  as  has  already  appeared  from  the  discus- 
sion of  permanent  investments,  are  either  those  which  repre- 
sent the  temporary  disposal  of  surplus  cash,  or  those  acquired 
in  payment  of  debts,  or  otherwise,  and  held  for  realization  at 
a  suitable  price.  Such  investments  have  no  relation  whatever 
to  the  business,  and  can  be  disposed  of  without  in  any  way 
interfering  with  its  earning  capacity,  other  than  the  loss  of 
the  dividends  thereon. 

Unissued  Stock  or  Bonds 

For  reasons  fully  explained  in  the  next  chapter,  it  is  not 
proper  to  include  under  this  caption,  or  indeed  as  an  asset 
at  all,  stocks  or  bonds  of  the  corporation  itself  when  these 
are  merely  held  in  the  treasury  for  future  issue ;  and,  more- 
over, there  may  be  grave  danger  in  so  including  these,  in 
that,  if  stated  at  par  when  the  market  value  is  less,  they 
may  be  seriously  overvalued  ;  while,  if  stated  at  market  value, 
not  only  has  an  apparent  loss  or  profit  to  be  provided  for, 
which  is  purely  a  capital  item  relating  only  to  capital  liabili- 
ties, but  also  the  market  price  probably  could  not  be  realized 
if  it  were  attempted  to  make  any  considerable  sale. 


BALANCE     SHEET     ASSETS  II7 

Issued  Stock  or  Bonds  Held  in  Treasury 

This  principle  should  strictly  be  extended  to  temporary 
purchases  of  the  corporation's  own  stock  or  bonds,  for  what- 
ever reason  made,  or  at  any  rate  such  holdings  should  be 
separately  stated.  In  the  majority  of  cases,  however,  it  has 
been  customary  up  to  the  present  time  to  treat  such  holdings 
as  ordinary  investments,  and  when  they  are  small  in  amount 
and  readily  saleable  at  market  price,  there  is  no  serious  objec- 
tion to  such  course  from  an  accounting  standpoint.  More- 
over, there  is  a  good  argument  for  making  a  distinction 
between  such  stocks  held  in  treasury,  unissued,  and  those 
bought  in  the  market,  in  that  the  former  can  only  be  legally 
issued  at  par  or  over,  while  the  latter  can  be  sold  at  any 
price  obtainable.  The  most  careful  consideration,  however, 
is  required  before  the  inclusion  of  a  corporation's  own  stock 
or  bonds  in  current  assets  should  be  permitted,  for  the  reason 
that  abuses  may  easily  be  concealed  from  stockholders  and 
investors  by  such  means. 

Valuation  of  Investments 

Investments  should  be  carried  on  the  balance  sheet  at 
cost  unless  the  market  value  is  below  cost,  when  they  should 
be  written  down  to  market  value.  An  objection  to  an  actual 
market  valuation  in  the  balance  sheet  is  that  profits  and 
losses  are  thereby  created  which  cannot  be  definitely  ascer- 
tained until  the  investments  are  realized ;  but  when  the 
amounts  are  small  and  not  very  material  to  the  true  state- 
ment of  the  assets,  a  cost  valuation  may  be  permitted,  pro- 
vided that  any  depreciation  in  value  is  disclosed. 

Another  method  of  dealing  with  fluctuations  in  the  value 
of  marketable  investments  is  to  create  an  investment  fluctua- 
tion reserve,  either  out  of  estimated  or  realized  profits  on 
investments,  or  by  a  charge  to  Profit  and  Loss,  of  such  an 


Il8    ACCOUNTING    PRACTICE    AND    PROCEDURE 

amount  as  may  be  necessary  to  prevent  this  reserve  from 
showing  a  debit  balance;  and  by  charges  or  credits  to  this 
reserve  to  maintain  the  asset  at  market  value. 

Life  insurance  companies  in  the  United  States  are  now 
required  to  value  their  investments  in  bonds  on  an  amortiza- 
tion principle.  Taking  into  consideration  the  purchase  price, 
nominal  rate  of  interest,  term,  and  price  of  redemption,  the 
corresponding  true  or  effective  rate  of  interest  is  ascertained. 
This  rate,  on  the  cost,  is  carried  to  the  Income  account  in  the 
first  half  year,  and  the  balance  of  interest,  which  may  be  a 
credit  or  debit,  is  deducted  from  or  added  to  the  investment 
cost,  giving  a  new  figure  for  the  latter,  on  which  the  income 
for  the  next  half  year  at  the  effective  rate  is  calculated,  this 
proceeding  being  repeated  each  half  year  until  redemption 
or  sale.  In  permanent  investments  this  is  a  correct  method, 
but  it  ignores  fluctuations  in  value  due  to  the  varying  credit 
of  the  borrower  or  to  changes  in  market  interest  rates,  and 
if  sales  are  made  before  maturity  there  may  well  be  a  bal- 
ance of  profit  or  loss  to  be  provided  for  which  is  not  covered 
by  the  effective  interest  rate  which  has  been  adopted.  A 
word  of  caution  is  necessary  as  to  the  application  of  this 
principle  of  amortization  to  bonds  purchased  at  a  discount. 
The  discount  may  be  due  to  the  difference  between  the  nomi- 
nal rate  of  interest  on  the  bond  and  the  average  market  rate ; 
or  it  may  be  due  to  the  bad  credit  of  the  issuing  company. 
In  the  former  case  it  is  reasonable  to  suppose  that  the  bond 
may  be  held  until  payment  at  maturity ;  but  in  the  latter  a 
contingency  of  risk  exists  which  may  render  the  application 
of  the  amortization  principle  unwise.  If  the  amortization 
method  is  adopted,  it  is  desirable  also  to  set  up  a  reserve  to 
provide  for  such  possible  further  fluctuations. 

(4)  Cash 

The  statement  of  cash  in  a  balance  sheet  usually  pre- 


BALANCE     SHEET     ASSETS  1 19 

sents  little  difficulty.     It  will  consist  of  three  main  items, 
viz. : 

(i)  Cash  on  current  account  with  bankers. 

(2)  Cash   on    deposit   with    bankers    or   others   under 

varying  conditions. 

(3)  Cash  in  hands  of  officials  of  the  concern. 

Cash  on  Current  Account 

Cash  on  current  account  should  represent  the  actual 
amount  shown  by  the  banks'  accounts  to  the  credit  of  the 
customers,  less  any  checks  which  the  customer  may  have 
drawn  and  issued  before  the  closing  date  but  which  have  not 
been  presented  to  the  bank  for  payment ;  and  with  the  addi- 
tion of  any  drafts  or  other  negotiable  instruments  which  are 
at  the  closing  date  in  the  hands  of  the  banker  for  collection 
but  have  not  been  collected.  Sometimes,  with  a  view  either 
of  showing  smaller  amounts  due  by  debtors  or  to  creditors, 
or  a  larger  balance  of  cash,  the  cash  book  is  not  closed  on  the 
proper  date,  but  is  kept  open  and  entries  of  receipts  and  pay- 
ments are  made  of  a  date  later  than,  but  relating  to  the 
transactions  prior  to,  the  closing  date.  This  practice  is 
entirely  incorrect  and  should  never  be  permitted.  The  object 
of  closing  the  books  on  a  given  date  is  to  ascertain  the  posi- 
tion on  that  date,  and  the  balance  sheet  cannot  accurately 
show  this  position  if  items  of  accounts  receivable  and  pay- 
able are  shown  as  if  they  had  been  received  and  paid  respec- 
tively on  or  before  the  closing  date,  when  as  a  matter  of  fact 
this  is  not  the  case. 

Outstanding  Checks 

The  important  consideration  in  the  case  of  checks  issued 
is  whether  certain  portions  of  the  bank  account  have,  by  the 
issue  of  orders  in  favor  of  creditors,  been  disposed  of  on  or 
before  the  closing  date,  and  this  cannot  be  so  unless  the  checks 
have  actually  been  mailed  prior  to  that  date.    If  they  have 


I20    ACCOUNTING    PRACTICE    AND    PROCEDURE 

actually  been  so  mailed,  the  mere  fact  that  at  that  time  the 
amount  is  still  at  the  credit  of  the  bank  account  is  not  ma- 
terial, because  it  is  no  longer  disposable.  Until  the  checks 
are  actually  mailed  this  cash  is  disposable,  because  the  checks 
can  always  be  cancelled  and  withdrawn.  It  may  be  said  that 
until  the  check  is  actually  presented  to  the  bank  and  paid, 
the  amount  is  disposable,  because  payment  can  always  be 
stopped.  Technically,  this  is  so,  but  in  practice  a  check  once 
issued  is  rarely  stopped,  except  to  protect  the  creditor  against 
loss  in  the  mail  or  otherwise,  so  that  this  contingency  need 
not  as  a  rule  be  considered. 

Restricted  Cash  Balances 

In  stating  bank  balances  in  the  balance  sheet,  it  is  im- 
portant that  any  amounts  that  are  not  free  for  all  purposes 
should  be  stated  separately  with  an  explanation  of  the  nature 
of  the  restriction  on  their  use.  Some  of  the  purposes  for 
which  these  restrictions  may  exist  would  be  the  following: 

Cash  received  on  account  of  new  issues  of  securities 
and  only  available  for  capital  expenditure. 

Cash  deposited  with  trustees  for  payment  of  bonded 
or  other  debt  or  interest  thereon. 

Cash  deposited  on  an  agreement  that  it  will  not  be 
withdrawn  before  a  certain  date. 

It  is  also  preferable  to  divide  the  free  cash  balances  so  as 
\      to  distinguish  between  currency  on  hand  and  balances  at 
banks  bearing  interest  and  not  bearing  interest  respectively. 

(5)  Foreign  Exchange 

Important  questions  relating  to  accounts  arise  where 
assets  are  situated,  or  expenses  or  liabilities  are  incurred,  in  a 
foreign  country  having  a  different  currency  from  the  home 
country.  In  the  statement  of  current  assets  it  is  necessary 
to  consider  the  value  in  terms  of  the  home  currency.    When 


BALANCE     SHEET     ASSETS  121 

the  fluctuations  in  exchange  are  merely  those  due  to  the 
varying  rate  for  bills  of  exchange  between  two  gold  standard 
countries,  a  fixed  par  of  exchange  can  be  adopted  in  ordinary 
commercial,  as  distinct  from  banking  transactions,  with 
safety  and  substantial  accuracy.  Between  countries  which 
do  not  have  the  same  metallic  standard,  and  one  or  both  of 
whose  currencies  are  depreciated  and  subject  to  daily  fluc- 
tuation due  to  causes  other  than  the  supply  and  demand  for 
bills,  it  is  necessary  to  adopt  different  methods. 

On  operations  carried  on  in  the  foreign  country,  the 
object  should  be  to  obtain  as  nearly  as  possible  an  exact 
equivalent  at  cost  in  the  home  country  for  all  assets  or  lia- 
bilities created  and  all  revenue  earned  or  expenditure  in- 
curred in  the  foreign  country.  So  long  as  a  transaction  orig- 
inates and  is  completed  in  the  foreign  country,  no  question  of 
exchange  comes  into  the  calculation.  Where,  however,  it 
has  created  an  asset  or  liability,  or  is  incomplete  at  a  closing 
date,  or  in  the  process  of  its  completion  passes  from  one 
country  to  another,  a  change  in  the  basis  of  value  occurs, 
which  must  be  reflected  in  the  accounts. 

Assume  that  an  American  firm  or  corporation  carries  on 
a  manufacturing  business  in  a  country,  such  as  China,  having 
a  silver  standard  currency. 

At  first  money  may  be  remitted  to  China  for  construc- 
tion of  works  and  will  realize  a  certain  sum  in  silver; 
machinery  and  other  materials  for  construction  purposes 
may  be  purchased  in  the  United  States  in  gold  and  shipped 
to  China,  and  other  purchases  may  be  made  in  China  in 
silver.  The  capital  cost  of  construction  should  be  stated  at 
the  actual  United  States  money  expended,  which  will  be 
represented  by  (i)  cash  remitted  to  China,  and  (2)  cash 
payments  in  the  United  States  for  purchases,  freights,  etc. 
As  long  as  the  whole  business  done  consists  of  construction 
chargeable  to  Capital  account,  and  the  principal  books  are 


122    ACCOUNTING    PRACTICE    AND     PROCEDURE 

kept  in  United  States  currency,  no  question  of  exchange 
arises.  But  if  the  books  are  kept  in  Chinese  currency 
(taels),  it  is  important  to  consider  what  rate  of  exchange 
should  be  used. 

So  far  as  cash  remittances  are  concerned  the  actual 
amount  realized  in  Chinese  currency  should  be  taken ;  for 
payments  in  the  United  States  an  arbitrary  basis  must  be 
adopted,  and  the  most  accurate  would  be  the  equivalent  in 
Chinese  currency  of  the  United  States  invoice  at  the  rate  of 
exchange  on  the  date  of  shipment.  The  United  States  office 
should  keep  a  current  account  with  the  Chinese  office,  show- 
ing in  one  column  the  dollar  and  in  another  the  tael  equiva- 
lent for  each  transaction. 

When  the  construction  period  is  finished,  charges  from 
the  United  States  may  consist  of  stores  and  supplies,  or 
materials  for  repairs  and  renewals  of  machinery  shipped, 
and  other  payments  made  by  the  United  States  for  the 
Chinese  office.  All  these  inter-country  transactions  should  be 
put  through  the  current  account  in  United  States  currency, 
with  the  equivalent  in  Chinese  currency  at  the  current  rate 
of  exchange  on  the  day  of  shipment  for  shipments  made  to 
the  Chinese  office,  and  on  the  day  of  payment  for  payments 
made  for  it.  Similarly  the  Chinese  office  will  put  through 
its  current  account  with  the  United  States  office  in  taels,  and 
at  the  exchange  of  the  day  in  dollars,  all  transactions  be- 
tween the  two  offices  which  originate  in  China.  As  long  as 
the  business  is  confined  to  construction  this  method  requires 
no  modification;  but  when  construction  and  operation  are 
carried  on  concurrently,  the  basis  on  which  materials,  stores 
and  supplies  should  be  charged  out  requires  consideration. 

If  these  materials  are  taken  up  in  the  Chinese  books 
at  the  tael  equivalent  on  date  of  shipment  from  United 
States,  and  between  that  date  and  the  date  of  consumption 
there  is  considerable  fluctuation  in  the  rate  of  exchange, 


BALANCE     SHEET     ASSETS  I23 

then  the  charge  to  the  respective  construction  and  oper- 
ating accounts  will  be  greater  or  less  than  the  true  value, 
according  as  the  rate  of  exchange  is  lower  or  higher,  for 
the  reason  that  the  number  of  Chinese  taels  representing 
the  materials,  etc.,  consumed  is  now  worth  either  more  or 
less  than  the  number  of  United  States  dollars  at  date  of 
shipment,  while  the  intrinsic  value  of  the  materials  in 
United  States  dollars  is,  so  far  as  exchange  questions  are 
concerned,  unchanged.  The  most  satisfactory  method  of 
dealing  with  this  condition  is  to  keep  the  accounts  of 
materials,  stores  and  supplies  originating  in  the  United 
States  in  United  States  currency  until  they  are  used,  and 
then  to  charge  them  out  to  the  accounts  concerned — 
whether  construction  or  operating — at  the  rate  of  ex- 
change current  on  the  date  of  issue  for  consumption;  in 
other  words,  these  materials,  etc.,  while  in  fact  in  China, 
are  deemed  to  be  in  the  United  States  until  issued  for 
consumption,  and  are  only  then  passed  through  the  cur- 
rent accounts  between  the  two  of^ces. 

The  business  being  an  American  one,  it  is  desirable 
that  its  results  should  be  expressed  in  United  States 
rather  than  in  Chinese  currency.  This  involves  the  pe- 
riodical conversion  of  its  capital  and  current  assets  and  its 
current  liabilities  from  taels  into  dollars.  Assuming  that 
the  capital  assets  are  kept  in  the  Chinese  books  in  taels, 
it  is  important  that  the  rate  used  for  conversion  should 
be  that  at  which  the  expenditures  were  originally  in- 
curred. If  a  higher  or  lower  value  of  the  tael  be  adopted, 
the  asset  will  be  correspondingly  understated  or  over- 
stated in  dollars.  To  obviate  this  result  it  is  necessary 
that  the  dollar  and  tael  equivalent  of  each  construction 
item  as  on  the  date  of  the  first  charge  to  construction 
account  be  both  kept  in  parallel  columns  continuously, 
and  only  the  dollar  equivalent  so  shown  be  taken  for  pur- 


124    ACCOUNTING    PRACTICE    AND    PROCEDURE 

poses  of  accounts  as  the  value  in  United  States  currency. 
This  result  is  of  course  better  obtained  by  transferring  all 
construction  expenditures  directly  to  the  United  States 
books  as  scon  as  charged;  and  in  practice  this  may  be 
done  with  substantial  accuracy  by  so  transferring  all 
charges  for  a  month  at  the  average  rate  of  exchange  for 
that  month.  Construction  expenditures  having  been  thus 
transferred  through  the  current  account  between  Chinese 
and  United  States  books  to  the  latter,  this  account  will, 
by  comparison  of  all  Chinese  and  American  equivalents, 
for  the  year  or  other  period  for  which  the  accounts  are 
being  stated,  give  an  average  rate  of  exchange  for  that 
period;  which,  applied  to  all  remaining  items  in  the  Chi- 
nese books,  including  earnings,  expenditures,  current 
assets  and  liabilities,  will  convert  them  at  this  average 
rate  of  exchange  into  an  exact  equivalent  in  United 
States  currency. 

If  construction  expenditures  are  maintained  in  the 
Chinese  books,  then  there  will  be  on  conversion  a  loss  or 
profit  representing  the  difference  between  the  actual 
United  States  figures  as  shown  by  the  dollar  equivalent 
at  time  of  expenditure,  and  the  equivalent  at  the  current 
average  rate,  and  this  difference  can  only  be  debited  or 
credited  to  the  United  States  Income  account. 

There  will  also  be  a  further  debit  or  credit  to  Profit 
and  Loss  account  for  the  difference  between  the  United 
States  equivalent  of  the  Chinese  value  of  the  current 
assets  and  liabilities  at  the  average  rate  of  exchange  and 
at  the  current  rate  at  the  date  as  of  which  the  accounts 
are  being  prepared;  it  being  necessary  in  the  case  of  these 
current  assets  and  liabilities  to  state  them  at  their  actual 
value  at  the  date  of  the  account. 

Such  an  elaborate  method  of  dealing  with  foreign 
transactions    is    not    often    found    necessary    in    practice. 


BALANCE    SHEET    ASSETS  125 

Most  of  the  important  countries  of  the  world  now  have  a 
gold  standard,  and  any  difference  in  exchange  due  to  the 
employment  of  the  fixed  par  value  of  the  gold  standards 
will  usually  be  a  small  one  and  can  be  absorbed  in  the 
Income  account  without  inquiry  as  to  its  origin.  It  may. 
however,  happen  even  in  such  cases  that  by  reason  of 
remittances  for  capital  purposes,  at  a  rate  differing  mate- 
rially from  the  par  of  exchange  during  the  whole  of  a 
construction  period,  a  considerable  difference  on  ex- 
change may  be  shown,  and  in  such  a  case  the  profit  or  loss 
in  exchange  should  be  treated  as  a  capital  item.  Even  in 
dealings  with  silver-using  countries  substantial  accuracy 
may  be  obtained  by  apportioning  any  profit  and  loss  on 
exchange  between  Capital  account  and  Income  account 
on  some  arbitrary  basis  determined  by  the  relation  of 
capital  to  other  expenditures. 

The  two  important  points  to  be  remembered  in  this 
connection  are:  firstly,  that  capital  outlays  should  be  rep- 
resented by  the  actual  amounts  of  cash  in  the  home  cur- 
rency expended  thereon;  and  secondly,  that  all  current 
assets  and  liabilities  should  be  converted  at  the  rate  cur- 
rent on  the  date  of  the  balance  sheet.  Further,  it  should 
be  noted  that  the  exchange  on  this  date  may  be  so  excep- 
tionally favorable  and  unlikely  to  be  maintained  that  it 
may  be  wise  policy  to  adopt  a  less  favorable  rate,  thus 
setting  up  a  reserve  against  possible  future  unfavorable 
fluctuations,  remembering  that  an  exceptionally  low  value 
of  the  foreign  currency  will  be  a  favorable  one  for  lia- 
bilities and  an  unfavorable  one  for  assets. 

Dealings  in  Foreign  Exchange 

The  problems  so  far  considered  have  relation  entirely 
to  commercial  accounts.  Others  arise  when  operations 
in  exchange  are  carried  out  by  bankers  or  brokers  for  the 


126    ACCOUNTING    PRACTICE    AND    PROCEDURE 

purpose  of  earning  profits  out  of  daily  fluctuations  in 
exchange  rates  due  to  the  demand  and  supply  for  money 
or  bills.  Such  operations  necessarily  involve  interest  as 
well  as  exchange.  The  transactions  being  all  in  effect 
for  cash  payable  or  receivable  now  or  at  some  short  future 
date  (being  then  represented  by  bills  of  exchange),  each 
one  has  its  exact  equivalent  in  the  currency  both  of  the 
originating  and  the  foreign  country.  If  it  were  not  for 
the  element  of  time  which  enters  into  the  question,  the 
determination  of  the  profit  on  any  series  of  transactions 
contained  in  one  account  would  be  made  as  already  de- 
scribed in  commercial  accounts,  viz. :  by  converting  the 
outstanding  balances  at  the  close  of  the  period  at  the  rate 
current  on  that  date.  Inasmuch,  however,  as  at  any 
closing  date  there  will  be  items  not  due  until  a  subse- 
quent date,  these  must  be  reduced  to  their  present  value 
at  the  closing  date,  and  this  present  value  converted  at 
the  current  rate  of  exchange  on  that  date.  The  balance 
on  that  account  will  be  the  profit  or  loss  thereon,  which 
by  custom  among  bankers  is  usually  considered  as  arising 
partly  from  interest  at  either  market,  or  some  customary 
rate,  and  partly  from  fluctuations  in  exchange.  In  order 
to  show  these  two  profits  separately  on  any  one  account, 
it  is  necessary  to  calculate  interest  on  every  item  up  to  the 
closing  date,  or  at  the  customary  rate  adopted  for  all 
transactions.  The  balance  of  these  interest  items  will  be 
the  interest  profit  or  loss,  and  the  remaining  balance, 
after  closing  the  account  as  already  described,  will  be  the 
exchange  profit  or  loss. 

The  subject  of  foreign  exchange  is  an  exhaustive  one 
and  there  are  various  methods  in  force  for  carrying  out  in 
practice  the  principles  laid  down.  For  further  explana- 
tions on  this  subject,  reference  should  be  made  to  the 
various  text  books. 


CHAPTER  VI 

ft 

BALANCE  SHEET  LIABILITIES 

(i)   Capital  Stock 

Capital  stock  of  a  corporation  is  firstly  authorized  by 
its  charter  or  constitution ;  secondly,  created  by  resolution  of 
the  board  of  directors;  and  thirdly,  issued  to  the  stock- 
holders either  for  cash  or  for  other  valuable  consideration. 
This  statement,  however,  requires  modification.  Accord- 
ing to  the  law  of  most  of  the  United  States,  and  of  Great 
Britain,  capital  stock  cannot  be  issued  except  for  value; 
but  this  legal  difficulty  is  avoided  by  issuing  it  in  accord- 
ance with  a  contract  in  the  body  of  which  is  contained  a  state- 
ment as  to  value  conformable  to  the  stock  or  other  securi- 
ties to  be  issued,  and  the  excess  of  this  value  over  that  of 
the  actual  tangible  assets  acquired  is  often  euphemistic- 
ally entitled  goodwill.  In  effect,  as  is  shown  by  the  mar- 
ket quotations  for  such  stocks,  they  have  frequently  been 
issued  at  a  discount,  i.  e.,  to  a  par  value  in  excess  of  the  true 
value  of  the  concern. 

While  this  fiction  has  so  far  maintained  its  legal  sanc- 
tion, it  still  remains  doubtful  how  far  an  issue  of  stock  for  a 
cash  consideration  clearly  less  than  its  par  value  is  legal, 
or  whether  if  so  issued  the  purchaser  or  holder  is  not 
liable  to  pay  up  the  whole  of  the  discount,  at  any  rate  on 
liquidation  of  the  corporation.  This  is  the  law  in  Eng- 
land— with  the  exception  that  it  is  now  legal  for  a  cor- 

127 


128    ACCOUNTING    PRACTICE    AND    PROCEDURE 

poration  to  pay  a  reasonable  commission  for  services  in 
placing  its  stock — and  it  is  also  the  statute  law  of  some 
of  the  United  States,  notably  New  York.  Discount  on 
stock  would  therefore  either  be  an  asset  of  the  corpora- 
tion recoverable  from  some  person  or  persons  and  not 
chargeable  to  profit  and  loss,  or  the  liability  on  the  stock 
would  be  the  amount  actually  paid  for  it.  Premiums  on 
stocks  issued  may  be  a  source  of  surplus  to  the  corpora- 
tion eventually,  because  they  are  cash  received  in  excess 
of  the  authorized  capital  which  must  be  maintained  in- 
tact, but  they  are  not  profit  on  operations  and  should  not 
therefore  be  credited  as  such  to  Income,  although  they  may 
be  applied  to  make  good  depreciation  in  fixed  assets,  or 
exceptional  losses,  where  such  depreciation  or  losses  do  not 
arise  out  of  the  ordinary  business  of  the  corporation. 

In  the  case  of  both  discounts  (if  permissible)  and  pre- 
miums, the  proper  view  would  seem  to  be  that  the  stock 
is  sold  for  whatever  it  will  fetch,  and  that  any  discount  or 
premium  should  be  considered  as  a  deduction  from  or  addi- 
tion to  the  par  value  of  the  stock  on  the  face  of  the  balance 
sheet. 

Capital  Stock  Without  Par  Value 

This  view  is  reflected  in  a  law  recently  passed  by  the 
Legislature  of  the  State  of  New  York  which  permits  in- 
corporation with  shares  having  no  specific  par  value,  the 
shares  of  stock  representing  shares  in  the  surplus  of  assets 
over  liabilities  and  being  sold  from  time  to  time  for  what- 
ever they  will  bring.  Objection  has  frequently  been  taken 
to  the  absence  of  a  par  value  for  the  reason  that  it  might 
provide  opportunities  for  improper  manipulation  by  un- 
scrupulous promoters.  In  reply  to  this,  it  may  be  urged 
that  in  other  states  where  a  fixed  par  value  is  maintained 
and  where  the  law  provides  that  it  must  be  paid  in  cash, 


BALANCE     SHEET    LIABILITIES  129 

there  are  many  known  legal  methods  of  evading  these 
provisions  by  means  of  contracts,  and  unscrupulous  pro- 
moters find  no  difficulty  in  carrying  out  their  schemes 
while  the  legitimate  plans  of  more  scrupulous  people  are 
hampered.  It  is  difficult  to  see  how  the  absence  of  a  par 
value  can  give  more  opportunities  for  fraud  than  are 
available  under  existing  laws,  and  the  power  to  incor- 
porate on  this  plan  will  enable  shares  in  an  undertaking 
of  uncertain  or  speculative  value  to  be  issued  or  sold  on 
their  merits. 

As  long  as  stock  has  a  fixed  par  value  it  is  better,  theo- 
retically, to  treat  premiums  thereon  as  receipts  on  capital 
account,  but  no  serious  objection  can  be  raised  to  crediting 
them  to  profit  and  loss  surplus,  preferably  under  a  separate 
subheading. 

Redemption  of  Capital  Stock 

Provision  is  sometimes  made  for  the  redemption  of 
certain  classes  of  capital  stock  out  of  profits.  Such  a 
provision,  if  redemption  is  made  at  par,  acts  as  an  alloca- 
tion of  profits  to  capital  purposes  and  does  not  effect  a 
reduction  in  surplus.  There  is  no  difference  whatever,  so 
far  as  the  financial  results  are  concerned,  between  the  ap- 
plication of  profits  to  increase  fixed  assets  or  to  reduce 
capital  liabilities.  The  proportion  of  the  profits  so  ex- 
pended is — at  any  rate  temporarily — locked  up  and  capi- 
talized, but  may  at  any  time  be  made  available  by  raising 
further  capital.  When  stock  is  redeemed  at  either  a  pre- 
mium or  a  discount,  an  actual  loss  or  profit  has  been 
realized — which  can  only  be  met  by  a  charge  against  or 
credit  to  profit  and  loss — resulting  not  from  the  business 
activities  but  from  a  change  in  capital.  In  fact  the  value 
of  the  shares  of  the  remaining  stockholders  has  been  de- 
pleted or  added  to  by  the  transaction,  where  the  pre- 


130    ACCOUNTING    PRACTICE    AND    PROCEDURE 

mium    (or  discount)    is  not  the  exact  proportion  of  the 
surplus  (or  deficit)  belonging  to  the  shares  redeemed. 

Treasury  Stock 

An  important  question  arises  as  to  the  treatment  of 
stock  of  a  corporation  held  in  its  own  treasury.  Many 
corporations  still  treat  this  as  an  investment  asset,  either 
under  a  special  division  of  the  balance  sheet  or  among  the 
current  assets. 

The  Interstate  Commerce  Commission  in  its  railway 
balance  sheet  formerly  made  the  same  requirements, 
but  in  the  forms  more  recently  issued  it  requires  that 
the  correct  accounting  methods  detailed  below  be 
followed.  A  little  consideration  will  show  that  such  a 
practice  is  entirely  erroneous  and  misleading,  and  more- 
over, that  it  also  raises  difficult  questions  of  valuation. 
/The  capital  stock  represents  the  manner  in  which  its 
property  and  assets  are  distributed  among  those  who 
constitute  the  corporation.  If  one  of  these  owners  dis- 
poses of  his  share  to  the  corporation,  he  withdraws  there- 
from, taking  with  him  what  he  considers  his  fair  propor- 
tion of  the  assf  t  value,  and  leaving  the  rest  to  be  divided 
among  the  remaining  owners.^  Assuming  that  the  seller 
gets  full  value,  the  value  remaining  to  the  others  is  neither 
more  nor  less  in  fact  than  it  was  before,  although  if  the 
stock  is  actually  worth  more  or  less  than  its  par  value, 
there  will  be  an  apparent  profit  or  loss  on  the  transaction; 
the  effect  of  which  may  be  thus  illustrated.  A  corpora- 
tion has  a  capital  stock  of  $1,000,000,  divided  into  10,000 
shares  of  $100  each,  and  represented  by  assets  of  equal 
value.  The  holders  of  1,000  shares  withdraw,  i.  e.,  sell 
their  shares  to  the  company  at  the  book  value,  which  in 
this  case  is  par.  The  stock  is  thereby  reduced  to  9,000 
shares,  i.  e.,  $900,000,  and  the  assets  are  similarly  reduced 


BALANCE     SHEET     LIABILITIES  13I 

by  the  payment  of  $100,000  to  $900,000.  There  is  clearly 
no  reason  whatever  for  pretending  that  there  are  still 
10,000  shareholders  and  assets  of  $1,000,000,  when  as  a 
matter  of  fact  there  are  only  9,000  with  assets  of 
$900,000,  and  the  position  of  these  9,000  is  entirely  un- 
changed. 

A  similar  result  would  appear  if  the  capital  stock  was 
originally  only  $800,000,  with  assets  of  $1,000,000,  and 
therefore  a  surplus  of  $200,000.  If  holders  of  800  shares 
withdraw,  taking  $100,000  of  cash  or  other  assets,  i.  e., 
the  book  value  of  the  stock,  the  position  of  the  remaining 
stockholders  is  unaltered. 

If  more  or  less  than  the  book  value  of  the  withdrawn 
shares  is  paid,  then  tiie  remaining  shareholders  have  on 
paper  sustained  a  loss  or  realized  a  profit;  but  whether  or 
no  this  is  a  real  loss  or  profit  depends  upon  the  intrinsic 
value  rather  than  the  book  value  of  the  shares.  This 
paper  or  book  profit  or  loss  is  rightly  charged  or  credited 
to  Profit  and  Loss  account  as  a  special  item.  There  is  no 
possible  variation  from  this  result  in  the  most  complicated 
cases;  but  lawyers  have  devised  clever  legal  fictions  for 
pretending  that  the  stock  which  either  has  not  in  eflfect 
come  into  existence,  or  has  in  effect  gone  out  of  exist- 
ence, still  exists.  These  are  mainly  designed  to  evade  the 
law  that  capital  stock  cannot  be  issued  at  a  discount;  and 
while  in  many  cases  no  doubt  they  are  harmless  in  their 
results,  in  others  they  are  made  use  of  for  improper  purposes. 
As  an  instance  of  such  a  device,  it  is  found  that  on  the 
purchase  of  an  undertaking  by  a  corporation  a  large  block 
of  stock  is  issued  to  the  vendor,  of  which  a  proportion  is 
returned  to  the  corporation  as  a  gift.  In  effect  this  stock 
so  returned  acts  as  a  reduction  of  the  purchase  money, 
and  both  cost  of  property  and  capital  stock  should  be 
correspondingly  reduced.     In  practice,  the  stock  having 


132    ACCOUNTING    PRACTICE    AND    PROCEDURE 

been  apparently  legally  issued  at  par,  subject  to  the  very 
doubtful  possibility  of  any  attack  being  made  on  the 
validity  of  the  contract,  can  now,  when  it  returns  to  the 
corporation,  be  sold  at  a  discount  below  par,  and  if,  as 
may  well  happen,  the  stock  has  been  taken  onto  the  books 
at  a  figure  well  below  par,  the  ultimate  effect  is  that,  in 
spite  of  the  law  to  the  contrary,  the  stock  is  sold  by  the 
corporation  at  a  discount  and  the  discount  charged  to 
cost  of  property,  which  is  thus  considerably  inflated.  The 
effect  of  this  device  is  clearly  the  sale  of  the  stock  at  a 
discount,  but  this  is  concealed  from  stockholders,  and  it 
would  undoubtedly  be  much  better  if  the  stock  had  no 
par  value  and  were  issued  at  whatever  price  it  would  fetch 
on  the  market,  without  the  necessity  for  such  juggling 
as  now  frequently  takes  place.  \  The  accounting  rule 
should  be  that  all  stock  in  possession  of  the  corporation 
which  issues  it,  should  be  deducted  from  the  liability 
shown  on  the  balance  sheet  so  as  to  truly  set  forth  the 
number  of  shares  in  the  undertaking  which  have  really 
been  issued  to  and  remain  in  the  hands  of  the  public  at  the 
date  of  the  balance  sheet. 

Another  objection  to  treating  such  stock  as  an  asset 
is  that,  not  being  held  as  necessary  for  the  purposes  of  the 
activities  of  the  company,  it  cannot  be  treated  as  a  perma- 
nent asset  and  maintained  at  cost,  but  must  be  written 
down  to  market  value,  if  below  cost,  thus  in  effect  unduly 
reducing  the  surplus  if  the  value  is  below  par,  or  unduly 
increasing  it  if  the  value  is  above  par. 

As  a  matter  of  convenience  small  amounts  of  such 
stock  are  carried  as  marketable  investments  when  the 
same  are  held  temporarily;  but  even  this  practice  is  open 
to  criticism  as  lending  itself  to  a  use  of  the  funds  of  a 
corporation  for  influencing  the  market  in  its  own  stock, 
which  is  not  one  of  the  purposes  for  which  it  is  permitted 


BALANCE     SHEET    LIABILITIES  I33 

to  exist.  A  desirable  amendment  to  the  existing  law 
would  be  one  that  would  make  it  illegal  for  a  corporation 
to  own  its  own  stock,  a  provision  which  is  already  in  force 
under  the  rules  of  the  New  York  Stock  Exchange. 

Treasury  Stock — English  Rule 

It  is  interesting  to  note  that  it  is  now  settled  law  in 
England  that  a  corporation  cannot  acquire  its  own  stock. 
In  the  well-known  case  of  Trevor  v.  Whitworth,  the 
House  of  Lords  held  that  a  corporation  could  not  acquire 
its  own  stock  on  the  general  grounds — 

( 1 )  That  the  corporation  cannot  be  a  member  of  itself ; 

(2)  That  the  purchase  of  its  own  shares  is  a  reduction 

of  capital  in  a  manner  not  sanctioned  by  the 
various  Companies  Acts ; 

(3)  That  such  a  purchase  is  a  return  of  a  part  of  the 

capital  to  the  stockholder  in  a  manner  not  author- 
ized; 

(4)  That  such  a  purchase  is  not  incidental  to  the  objects 

for  which  the  corporation  is  formed ; 

and,  underlying  the  above  grounds, 

(5)  That  the  capital  stock  paid  up  is  the  fund  to  which 

the  creditors  are  entitled  to  look  to  protect  them 
against  loss,  and  that  no  diminution  of  this  fund, 
except  in  the  manner  specifically  provided  iri  the 
statutes,  can  be  permitted. 

(2)  Bonded  Debt 

The  most  important  questions  which  arise  in  connec- 
tion with  bonded  debt  have  relation  to  the  premiums 
and  discounts  on  issue  and  redemption  thereof,  the 
methods  of  redemption,  and  the  proper  treatment  of 
funded  debt  held  in  the  treasury  of  the  debtor  company. 


134    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Effective  Interest  Rate  of  Bonds 

Premium  or  discount  on  bonds  is  a  deduction  from  or 
addition  to  the  nominal  rate  of  interest  which  the  bond 
carries;  that  is  to  say,  there  is  a  rate  known  as  the  true  or 
effective  rate  at  which  any  corporation  can  place  its 
bonds  at  par;  if  it  elects  to  place  them  at  any  other  rate 
the  bonds  will  sell  at  a  premium  or  discount  as  the  case 
may  be;  but  the  effective  rate  remains  the  same  and  this 
effective  rate  is  the  proper  charge  to  Income  account. 
Hence  the  premium  or  discount  should  theoretically  be 
spread  over  the  term  of  the  bonds,  and  the  annual  in- 
stalment thereof  credited  or  charged  to  Income  account 
each  year. 

It  should  be  remembered  that  the  effective  rate  must 
be  applied  not  to  the  par  value  but  to  the  cash  value  at 
time  of  issue  of  the  bonds ;  e.  g.,  for  bonds  issued  at  90  the 
effective  rate  will  be  calculated  on  $900  for  each  $1,000 
bond,  and  not  on  $1,000. 

Annual  Income  Charges 

Having  ascertained  this  true  or  effective  rate  on  the 
basis  of  the  terms  of  issue,  it  is  still  frequently  a  difficult 
matter  to  determine  the  charge  that  should  be  made  to 
Income  account  under  the  conditions  which  may  actually 
exist  in  the  future. 

If  an  issue  of  bonds  be  made  for  a  fixed  term  of  years 
at  a  certain  nominal  rate  of  interest,  with  provision  for 
the  redemption  of  a  specified  amount  each  year  at  fixed 
prices,  it  is  a  comparatively  simple  matter  to  determine 
the  present  value  of  all  the  repayments,  and  thence — by 
an  inspection  of  annuity  tables — the  equivalent  theoreti- 
cal interest  rate  on  the  basis  of  the  fixed  present  value  and 
term. 


BALANCE     SHEET     LIABILITIES  I35 

Varying  Conditions  Affecting  Annual  Charge 

In  accounting  for  the  charge  to  income  where  the 
effective  interest  method  is  adopted,  these  cases  must  be 
considered: 

(a)  Bonds  issued  at  a  discount  and  redeemable  at  par. 
When  the  bonds  are  first  issued  the  full  par  value  would 
be  credited  to  the  liability  account,  while  the  difference 
between  this  full  value  and  the  cash  received  would  be 
charged  to  a  discount  on  bonds  account.  The  full  effec- 
tive rate  of  interest  would  be  charged  to  Income  account, 
while  so  much  of  it  as  represents  the  nominal  interest 
would  be  credited  to  Interest  Accrued,  and  the  balance  to 
Bond  Discount,  thus  gradually  reducing  this  account 
over  the  life  of  the  bonds. 

(b)  Bonds  issued  at  a  premium  and  redeemable  at  par. 
The  conditions  are  exactly  the  reverse  of  case  (a).  Dis- 
count on  Bonds  account  will  become  Premium  on  Bonds 
account  with  a  credit  balance;  the  effective  interest  charge 
will  be  less  than  the  actual,  leaving  a  charge  to  Bond 
Premium  account  in  reduction  of  the  balance  on  that 
account. 

(c)  Bonds  issued  at  par,  redeemable  at  a  premium. 
This  case  is  in  substance  identical  with  (a),  but  in  practice 
the  treatment  is  different,  as  there  is  neither  discount  nor 
premium  at  the  date  of  issue.  The  charge  to  Income 
account  will  exceed  the  interest  accrued,  and  the  differ- 
ence will  be  credited  to  Bond  Premium  account  and  accu- 
mulated there  until  final  redemption,  all  premiums  paid 
on  redeemed  bonds  being  charged  to  this  account. 

(d)  Bonds  issued  at  a  discount  and  redeemable  at  a 
premium.  This  combines  cases  (a)  and  (c).  The  excess 
of  the  effective  rate  will  be  credited  to  Premium  and 
Discount  account,  and  will  gradually  convert  the  debit 


136    ACCOUNTING    PRACTICE    AND    PROCEDURE 

balance  on  that  account  into  a  credit  sufficient  to  equal  the 
amount  of  all  premiums  payable  on  final  redemption. 

In  practice  it  is  often  found  that  bonds  are  purchased 
in  the  market  at  prices  varying  from,  and  generally  less 
than,  the  specified  redemption  prices,  and  then  transferred 
to  the  trustees  of  the  sinking  fund  at  the  specified  prices, 
and  a  saving  thus  effected  which  must  be  taken  into  ac- 
count in  determining  the  annual  charge  to  income.  Or 
again,  the  redemption  dates  may  be  anticipated  for  a 
whole  or  part  of  the  issue,  and  further  disturbing  factors 
thus  introduced. 

The  saving  on  the  purchase  of  bonds  in  the  market  at 
prices  below  those  fixed  for  redemption,  may  be  dealt 
with  in  one  or  other  of  the  following  methods: 

(i)  Credit  the  amount  to  Income  account  each  year, 
thus  finally  disposing  of  it, 

(2)  Credit  the  amount  to  discount  (or  premium)  on 
Bonds  account,  thus  eventually  producing  a  surplus  on 
this  account,  which  would  ultimately  be  transferred  to 
Income  account. 

Neither  of  these  methods  is  theoretically  accurate; 
but  in  view  of  the  impossibility  of  determining  what  the 
market  price  will  be  in  the  future,  theoretical  accuracy  is 
impossible. 

The  treatment  in  the  case  of  anticipation  of  redemp- 
tion dates  is  a  more  difficult  matter,  for,  if  carried  out  on 
at  all  a  large  scale  and  not  accompanied  by  an  equitable 
reduction  on  the  redemption  price,  the  effective  interest 
rate  will  be  materially  increased.  The  only  sound  method 
would  appear  to  be  to  recalculate  the  effective  rate  on  the 
basis  of  the  bonds  still  outstanding  and  the  new  redemp- 
tion terms.  If  this  is  not  done,  there  may  be  a  consider- 
able shortage  to  make  up  at  the  date  of  final  redemption. 
This  fact  is  frequently  overlooked,  although  it  should  be 


BALANCE     SHEET     LIABILITIES  I37 

recognized   as    an    important    factor,    particularly   in    any- 
refunding  or  redemption  plan. 

Methods  of  Determining  Charge  to  Income 

There  are  various  methods  in  use  for  determining  the 
proper  interest  charge  to  be  made  to  Income  account 
under  the  varying  conditions  that  arise. 

The  first  and  most  correct  method,  which  may  be 
called  the  effective  interest  method,  consists  in  charging 
to  Income  account  the  effective  interest  rate  calculated 
from  the  known  conditions  of  issue  upon  the  whole 
amount  outstanding  during  the  year,  with  an  addition  or 
deduction  of  an  amount  equal  to  the  excess  or  deficit  of 
the  amount  paid  for  redemption  during  the  year  as  com- 
pared with  the  fixed  amount  provided.  For  instance,  if 
the  conditions  of  the  issue  provided  that  $100,000  of 
bonds  be  retired  during  the  year  at  105,  and  as  a  matter 
of  fact  they  are  purchased  at  95,  the  true  interest  on  the 
bonds  bearing  interest  during  the  year  would  be  reduced 
by  $10,000,  representing  the  saving  on  bonds  retired 
during  the  year  as  compared  with  the  price  therefor  as- 
sumed in  determining  the  effective  rate.  The  tendency  of 
this  method  would  probably  be  to  increase  gradually  the 
annual  charge  to  Income  for  interest  and  sinking  fund  until 
the  limit  price  of  redemption  was  reached ;  for,  as  the  amount 
of  bonds  outstanding  diminished,  the  market  price  might 
be  expected  to  rise. 

The  second  and  more  common  method,  which  may 
h6  called  the  equal  instalment  method,  is  to  ignore  alto- 
gether the  effective  interest  rate;  to  charge  to  Income 
account  each  year  the  interest  actually  paid,  together  with 
a  proportionate  part,  according  to  the  whole  term  of 
issue,  of  the  discount  on  issue  or  premium  on  redemption; 
Income  account  being  also  credited  with  any  savings 
made  by  purchase  of  bonds  in  the  market. 


138    ACCOUNTING    PRACTICE    AND    PROCEDURE 

A  third  method,  which  may  be  called  the  bonds  out- 
standing method,  and  which  may  safely  be  adopted  where, 
by  reason  of  complication  in  the  terms  of  issue  and  re- 
demption, it  is  difficult  or  impracticable  to  determine  the 
true  interest  rate,  is  to  distribute  the  discount  or  premium 
over  the  period  in  the  proportion  that  the  bonds  out- 
standing for  each  year  bear  to  the  sum  of  the  bonds  out- 
standing for  all  years  of  the  currency  of  the  loan.  Any 
saving  made  by  the  purchase  of  bonds  in  the  market  is 
credited  to  Income  account. 

When  a  large  accumulated  surplus  is  available,  the 
practice  is  frequently  adopted  of  charging  the  whole  dis- 
count on  issue  to  Profit  and  Loss  account,  taking  up  any 
profit  or  loss  on  subsequent  redemption  at  a  discount  or 
premium  to  the  credit  of  Profit  and  Loss  account  as  it 
arises,  and  leaving  the  nominal  interest  on  the  bonds 
actually  outstanding  each  year  as  the  only  charge  to  In- 
come account.  A  great  objection  to  this  practice  is  that 
thereby  the  true  rate  of  interest  paid  on  loans  during  their 
currency  is  entirely  lost  sight  of;  current  fixed  charges 
against  earnings  are  understated ;  and  the  portion  represent- 
ing the  discount  is  charged  against  surplus  arising  out  of 
previous  operations,  instead  of  against  income  from  current 
operations  which  should  meet  it.  Any  savings  on  bonds 
purchased  in  the  market  are  a  credit  to  Income  account. 

Operation  of  the  Various  Methods  of  Determining  Annual 
Charge  to  Income 

In  order  to  show  the  effect  of  these  various  methods, 
it  may  be  well  to  consider  a  specific  case  as  follows: 

An  issue  of  $1,000,000  of  bonds  is  made  at  90,  carry- 
ing interest  at  5  per  cent,  and  redeemable  at  the  rate  of 
$50,000  each  half  year,  at  100  for  the  first  five  years,  and 
thereafter  at  105.  Calculations  made  on  these  premises 
show  that  the  effective  rate  of  interest  is  approximately 


BALANCE     SHEET     LIABILITIES  139 

8  3/16  per  cent.  Bonds  are  redeemed  each  year  as  specified, 
but  they  are  purchased  in  the  market  at  the  following 
prices,  viz.: 

1st  Year 92 

2nd    " 93 

3rd  " 95 

4th  "     97 

5th  " 98 

6th  "     100 

7th  " 102 

8th  "     104 

9th  and  loth  drawn  at 105 

The  tables  that  follow  give  all  the  essential  figures. 

In  the  table  on  page  140,  the  last  four  columns  show 
the  charges  to  Income  account  on  the  basis  (5)  of  the  effec- 
tive interest  method;  (6)  of  the  equal  instalment  method; 
(7)  of  the  bonds  outstanding  method;  and  (8)  of  charging 
all  discount  and  premium  to  surplus;  in  each  case  credit- 
ing to  Income  account  the  surplus  arising  from  pur- 
chasing bonds  at  less  than  the  fixed  redemption  price. 

If  the  latter  be  credited  direct  to  surplus,  or  carried  in 
the  Bond  Discount  account  until  all  discount  has  been 
written  off  by  the  operation  of  these  credits  and  the  bal- 
ance of  the  effective  rate,  then,  at  the  end  of  the  nth 
half  year  in  the  first  case  and  at  the  end  of  the  15th  half 
year  in  the  second,  the  discount  will  be  extinguished  and 
thereafter  only  the  actual  interest  paid,  less  surplus  on 
market  purchases,  will  be  charged  to  Income. 

Determining  Annual  Charge  When  Proportionate  Discount 
is  Written  Off 

The  charge  to  Income  account  on  the  bonds  out- 
standing method  is  arrived  at  as  shown  in  the  table  on  page 
141.  It  is  so  close  to  that  given  by  the  effective  interest 
method  that  for  all  practical  purposes  it  may  safely  be 
adopted. 


I40 


ACCOUNTING   PRACTICE  AND   PROCEDURE 


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Period  J4  Year. 


Payments    for    Inter- 
est at  5%  p.a.  (a;. 


Effective  Interest 
charge  at  8  3-16% 
p.a.    (b). 


Discount 
for  (2) 


provided 
-  (1). 


Surplus  on  purchase 
at  less  than  re- 
demption price. 


Charge  to  Income  on 
effective  interest 
method. 


Charge  to  Income  on 
equal  annual  In- 
stalment   method. 


Charge  to  Income 
when  Discount 
written  off  on 
Bonds  outstanding 
method. 


Charge  to  Income 
when  Discount 
charged  to  Profit 
and    Loss   Account. 


BALANCE    SHEET     LIABILITIES  141 


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^  0 

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3 
0 

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0  , 

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1 

$1,000,000 

100 
1050 

$11,905 

$25,000 

$4,000 

$32,905 

2 

950,000 

95 
1050 

11,310 

23,750 

4,000 

31,060 

3 

900,000 

90 
1050 

10,714 

22,500 

3,500 

29,714 

4 

850,000 

85 
1050 

10,119 

21,250 

3,500 

27,869 

S 

800,000 

80 
1050 

9,524 

20,000 

2,500 

27,024 

6 

750,000 

75 
1050 

8,929 

18,750 

2,500 

25,179 

7 

700,000 

70 
1050 

8,333 

17,500 

1,500 

24,333 

8 

650,000 

65 
1050 

7,738 

16,250 

1,500 

22,488 

9 

600,000 

60 
1050 

7,143 

15,000 

1,000 

21,143 

10 

550,000 

55 
1050 

6,548 

13,750 

1,000 

19,298 

11 

500,000 

50 
1050 

5,952 

12,500 

2,500 

15,952 

12 

450,000 

45 
1050 

5,357 

11,250 

2.500 

14,107 

13 

400,000 

40 
1050 

4,762 

10,000 

1,500 

13,262 

14 

350,000 

35 
1050 

4,167 

8,750 

1,500 

11,417 

IS 

300,000 

30 
1050 

3,571 

7,500 

500 

10,571 

16 

250,000 

25 
1050 

2,976 

6,250 

500 

8,726 

17 

200,000 

20 
1050 

2,381 

5,000 

... 

7,381 

18 

150,000 

15 
1050 

1,786 

3,750 

... 

5,536 

19 

100,000 

10 
1050 

1,190 

2,500 

... 

3,690 

20 

50,000 
$10,500,000 

5 
1050 

595 
$125,000 

1,250 
$262,500 

1,845 

$34,000 

$353,500 

142    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Discount  on  Bond  Issues  Not  a  Proper  Charge  to  Capital 

Under  no  ordinary  circumstances  is  it  correct  to  treat 
discount  on  bond  issues  as  a  charge  to  capital.  It  does 
not  represent  any  property;  for  it  is  clearly  incorrect  to 
consider  that  the  cost  in  cash  of  a  piece  of  property  varies 
according  to  the  credit  of  the  purchaser  or  constructor. 
Hence,  where  any  such  discounts  have  been  charged  to 
capital  assets,  it  is  essential  for  a  proper  understanding 
of  the  balance  sheet  that  this  fact  should  be  clearly  set 
forth.  In  effect,  in  corporation  finance  such  discounts  are 
frequently  included  in  capital  expenditure,  as  are  many 
other  fictitious  items  which  represent  either  a  sanguine 
estimate  of  future  gains,  or  mere  "water";  and  this  is 
done  by  the  fiction  of  the  sale  of  the  property  to  a  new 
company  at  a  largely  inflated  value,  for  a  price  including 
the  par  value  of  the  bonded  debt;  the  intermediaries  in 
this  sale  then  selling  the  bonds  at  the  market  price.  This 
principle  has  been  extended  also  to  cases  of  reorganiza- 
tion effected  without  any  sale  of  assets,  where  the  dis- 
counts on  bonds,  as  well  as  bonuses  of  capital  stock  issued 
to  facilitate  the  completion  of  the  reorganization,  have 
all  been  capitalized.  These  exceptions  must  not  be  taken 
as  a  justification  for  a  similar  treatment  in  ordinary  cases 
of  financing;  and,  in  fact,  there  is  no  real  justification  for 
their  adoption  in  any  case,  beyond  that  of  expediency. 
The  whole  system  has  led  in  the  past  to  many  and  serious 
abuses,  and  the  more  strict  supervision  of  capital  issues 
which  is  now  being  extended  over  certain  classes  of  cor- 
porations, will  tend  to  put  a  stop  to  it  in  all  cases.  The 
objection  to  charging  discount  on  bond  issues  to  Capital 
account  must  not,  however,  be  held  to  include  such  a 
charge  of  the  annual  instalment  of  discount  for  the  period 
of  construction  during  which  interest  also  is  charged  to 


BALANCE     SHEET     LIABILITIES  143 

Capital  account.  The  rate  of  interest  chargeable  to  capi- 
tal should  be  the  actual  cost  of  the  money,  i.  e.,  the  effec- 
tive rate,  and  any  approximation  to  this  rate  obtained  by 
including  that  proportion  of  the  discount  which  belongs 
to  the  period  would  be  a  permissible  charge  to  capital. 

(3)  Available  Capital  Resources 

Corporations  frequently  express  a  desire  to  include 
created  but  unissued  stock  and  bonds  held  in  treasury  as 
assets,  on  the  ground  that  these  represent  available  capi- 
tal resources  and  are  therefore  of  value. 

It  is  submitted  that  the  value  lies  not  in  the  par  or 
other  value  of  these  securities,  but  in  the  fact  that  certain 
formalities  necessary  to  their  issue,  and  involving  expen- 
diture of  both  time  and  money,  have  been  complied  with, 
and  that  the  sale  alone  remains  to  be  made.  It  is  true 
that  in  some  cases  this  sale  may  be  merely  a  matter  of  a 
few  minutes'  talk  with  a  banker,  but  in  other  cases  it  may 
be  difficult  if  not  impossible.  In  reality  it  is  only  on  final 
sale  that  these  securities  become  of  any  real  tangible  value 
to  the  corporation;  and  the  intangible  value  resulting 
from  their  mere  creation,  or  even  their  use  as  collateral 
security,  is  not  properly  represented  by  treating  it  as  an 
asset  at  par  or  market  vahie. 

This  can  better  be  shown  in  the  schedule  of  capital 
liabilities  given  in  Chapter  II,  (p.  35),  and  the  total  of  the 
"Amount  in  Treasury"  column  for  both  stocks  and  bonds 
might  well  be  inserted  as  a  memorandum  in  the  balance 
sheet  after  the  main  heading  of  capital  liabilities,  but 
should  not  be  included  in  the  totals. 

(4)  Current  Liabilities 

The  subheadings  given  in  the  pro  forma  balance  sheet 


144  ACCOUNTING    PRACTICE    AND    PROCEDURE 

in  Chapter  II  are  almost  self-explanatory  and  call  for 
little  additional  comment. 

Current  bank  loans  and  commercial  paper  should  in- 
clude only  seasonal  advances,  i.  e.,  those  made  during  the 
part  of  the  year  when  outlays  are  heaviest,  and  repaid  in 
due  course  each  year  as  the  proceeds  of  sales  are  collected. 
It  is  frequently  difficult  to  draw  a  clear  distinction  be- 
tween current  loans  and  those  made  for  capital  purposes, 
particularly  when  working  capital  is  provided  in  this 
way,  but  indications  generally  exist  in  the  manner  in 
which  repayments  are  made  which  will  permit  of  a  proper 
classification.  For  instance,  loans  made  against  accounts 
or  bills  receivable,  and  repaid  as  they  are  collected,  would 
clearly  be  current  loans  even  though  they  are  immediately 
and  continuously  replaced  to  a  greater  or  less  extent  by 
further  loans  against  other  accounts  and  bills.  On  the 
othep  hand  a  continuous  bank  overdraft  by  arrangement 
with  the  bank,  not  of  fixed  amount,  but  varying  only 
according  to  the  payments  and  the  withdrawals  made  in 
the  ordinary  course  of  business,  would  more  properly  be 
considered  as  a  loan  for  capital  purposes.  Such  over- 
drafts are  very  common  in  England,  and  are  entirely  dif- 
ferent from  temporary  overdrafts  resulting  from  financial 
difficulties,  which  latter  should  be  treated  as  a  current 
liability. 

Such  items  as  percentages  retained  on  contracts  and  ac- 
counts for  goods  invoiced  and  at  risk  of  purchaser,  but 
not  received,  should  be  included  under  trade  accounts; 
but  where  there  is  a  trade  custom  to  invoice  goods  for 
new  season's  trade  some  months  before  the  same  are  used 
and  before  payment  is  due,  both  the  liability  and  the  asset 
(under  the  head  of  stock  in  trade)  are  frequently  omitted. 
While  there  is  the  justification  for  this  practice  that  the 
transaction  is  made  largely  for  the  convenience  of  the  seller, 


BALANCE     SHEET     LIABILITIES  I45 

who  is  anxious  to  save  storage  space,  and  not  for  that  of 
the  purchaser,  who  would  be  just  as  willing  to  take  de- 
livery at  a  date  nearer  to  his  requirements,  it  is  submitted 
that  the  true  position  of  the  purchaser  would  be  better  shown 
by  including  the  amount  on  both  sides  of  the  balance  sheet. 

Under  the  heading  of  miscellaneous  accounts  payable 
should  be  included  all  salaries,  wages,  and  other  payments 
accruing  and  due  from  day  to  day  and  payable  at  short 
intervals,  while  other  items  accruing  but  not  due  until 
some  subsequent  date,  such  as  interest,  taxes,  etc.,  would 
appear  under  the  next  heading  of  accrued  items. 

A  difficult  question  frequently  arises  as  to  the  period 
to  which  assessments  of  taxes  apply.  Generally  speaking, 
if  the  taxes — although  not  accrued  or  even  ascertainable 
— become  a  charge  or  lien  on  the  property  at  a  particular 
date,  they  should  be  provided  for  as  of  that  date,  at  any 
rate  by  estimate. 

The  confusion  in  the  same  state  and  even  in  the  same 
city  is  frequently  great,  and  it  is  difficult  to  ascertain  the 
facts  as  to  any  particular  tax.  The  only  safe  rule  is  to  err 
on  the  side  of  providing  too  much  rather  than  too  little. 

Provision  should  always  be  made  for  all  known  lia- 
bilities, even  when  the  exact  amounts  are  not  ascertain- 
able. Some  sort  of  approximate  estimate  can  always  be 
made,  and  should  be  included  under  the  heading  of  current 
liabilities  and  not  under  that  of  surplus  or  reserves,  for  the 
reason  that  a  real  liability  exists  and  should  be  provided  for 
in  order  to  show  the  true  position. 

(5)  Contingent  Liabilities 

This  term  is  used  to  denote  a  liability  which  may  or 
may  not  arise  out  of  transactions  entered  into  in  the  past, 
and  in  the  former  event  will  result  in  a  correspondins:  addi- 


146    ACCOUNTING    PRACTICE    AND    PROCEDURE 

tion  to  the  assets.  This  addition  will  as  a  rule  be  of  equal 
value  to  the  liability,  but  it  may  be  either  more  or  less. 

The  most  usual  contingent  liabilities  are  the  follow- 
ing: 

(i)  Liability  on  bills  discounted,  being  the  obligation 
arising  from  the  indorsements  on  the  bills  when  dis- 
counted to  take  up  the  bills  at  their  face  value  if  the 
maker  does  not  do  so.  In  this  case  the  liability  is  a  defi- 
nite fixed  value,  while  the  corresponding  asset  depends 
on  the  ability  of  the  maker  of  the  bill  to  pay,  and  this 
ability  must  be  judged  and  valued  in  the  same  manner  as 
his  ability  to  pay  accounts  or  bills  not  discounted. 

(2)  Liability  on  shares  in  corporations  not  fully  paid 
up,  being  the  undertaking  to  pay  up  the  par  value  of  the 
shares  when  called  on.  As  this  payment  increases  cor- 
respondingly the  assets  of  the  corporation,  the  asset  value 
will  as  a  rule  equal  the  amount  of  the  call.  It  may,  how- 
ever, happen  that  the  call  is  made  to  make  good  lost 
assets,  or  pay  the  creditors,  and  in  such  case  it  may  repre- 
sent no  value  at  all,  and  a  corresponding  reserve  will  be 
required. 

(3)  Liability  on  guarantees  of  principal  or  interest  of 
loans  to  other  persons  or  corporations.  If  such  loans  are 
fully  secured  and  the  guarantee  has  eventually  to  be  made 
good,  at  least  an  equivalent  in  property  value  would  be 
acquired.     If  not,  a  reserve  might  be  required. 

Two  other  classes  of  liability  may  be  considered  under 
this  hqad  which  are  of  a  somewhat  different  character. 

(i)  Liability  on  contracts  to  make  good  defects  in 
work  done  or  goods  supplied.  This  must  always  be  a 
matter  of  expense  without  any  corresponding  asset,  and 
a  reserve  to  meet  such  contingent  liabilities  must  always 


BALANCE     SHEET     LIABILITIES  I47 

be  provided  in  full  of  all  expected  claims.  In  fact,  this 
class  of  items  should  not  appear  at  all  under  contingent 
liabilities  but  under  current  liabilities. 

(2)  Liability  on  contracts  for  purchase  or  sale  for 
future  delivery.  These  contracts  are  of  two  kinds:  (a) 
those  in  products  dealt  in  on  produce  exchanges  at  prices 
which  fluctuate  from  day  to  day — or  speculative  contracts; 
and  (b)  those  made  at  fixed  prices  for  future  requirements 
of  the  business. 

The  measure  in  the  former  case  is  the  difference  be- 
tween the  future  price  at  date  of  contract  and  date  of 
valuation,  and  this  may  represent  either  an  asset  or  liability, 
which  is  only  contingent  in  that  it  differs  from  the  asset 
or  liability  value  that  will  ultimately  accrue.  It  properly 
belongs  in  either  current  assets  or  current  liabilities,  and 
has  no  place  under  the  heading  of  contingent  liabilities. 

The  latter  class  of  items  may  be  and  are  usually 
ignored  altogether,  on  the  ground  that  the  contracts  are 
made  in  the  ordinary  course  of  business,  and  that  no 
liability  really  arises  until  the  other  party  to  the  contract 
performs  his  part  of  it;  and  inasmuch  as,  until  perform- 
ance, the  actual  value  of  the  corresponding  asset  may  usually 
be  taken  as  equal  to  the  liability  value,  this  treatment  is  safe. 
Circumstances  might  arise — as  in  the  case  of  wide  fluctua- 
tions between  the  contract  price  and  the  value  at  the  date  of 
the  balance  sheet — which  would  require  the  creation  of  some 
reserve  or  even  justify  an  asset  value  in  excess  of  the 
liability. 

The  usual  method  of  treatment  of  contingent  liabili- 
ties is  by  a  footnote  to  the  balance  sheet  under  this  head- 
ing, no  values  being  carried  into  the  totals  of  either  assets 
or  liabilities,  and  inasmuch  as  in  the  majority  of  cases 
values  cannot  be  definitely  stated,  this  method  seems  the 
most  satisfactory.    Alternatively,  however,  (i)  both  assets 


148    ACCOUNTING    PRACTICE    AND    PROCEDURE 

and  liabilities  are  increased  under  the  respective  headings 
by  the  liability  value;  or  (2)  main  headings  of  "Contingent 
Assets"  and  "Contingent  Liabilities"  are  created  in  the 
body  of  the  balance  sheet,  and  the  values  included  in 
both  totals.  In  the  case  of  bills  discounted  a  satisfactory 
method  is  to  state  the  full  amount  of  all  unmatured  bills 
among  the  current  assets,  deducting  therefrom  on  the 
face  of  the  balance  sheet  the  amount  discounted. 

(6)  Sinking  Fund  Reserves  for  Redemption  of  Debt 
Sinking  Fund  or  Debt  Extinguishment  Reserves  are 
not  in  theory  a  charge  against  Income,  for  the  reason 
that  they  do  not  represent  a  loss  or  expense,  but  the 
extinction  of  an  existing  liability.  Inasmuch,  however, 
as  in  most  cases  the  only  source  out  of  which  such  re- 
demption reserve  can  be  provided  is  the  surplus  earnings,  it 
is  quite  usual  to  insert  a  provision  in  trust  deeds  that  the 
sinking  fund  reserve  is  to  be  provided  out  of  the  profits  of 
the  year.  The  discharge  of  liabilities  involves  either  a  cor- 
responding reduction  in  assets,  or  the  accumulation  of 
other  liabilities  or  surplus,  A  reduction  in  current  assets 
or  the  accumulation  of  other  liabilities  as  a  substitute  for 
bonded  indebtedness,  is  clearly  objectionable,  and  it  is 
therefore  desirable  that  the  amount  applied  each  year 
to  sinking  fund  purposes  should  be  offset  by  the  retention 
in  the  business  of  a  corresponding  amount  of  profit, 
which  should  be  transferred  either  to  a  special  reserve,  or 
in  reduction  of  some  fixed  asset  account  by  way  of  pro- 
vision for  depreciation  or  otherwise.  In  the  latter  case 
it  must  be  remembered  that  the  provision  for  depreciation 
will  be  to  that  extent  represented  by  capital  instead  of 
current  assets,  and  while  there  is  no  theoretical  objection 
to  this  if  the  depreciation  account  is  sufficiently  large,  the 
latter  necessarily  ceases  to  be  available  in  cash  for  one  of 


BALANCE     SHEET     LIABILITIES  149 

its  principal  purposes,  viz.,  the  renewal  of  various  capital 
assets  from  time  to  time.  If,  however,  part  of  the  fixed 
assets  is  of  a  wasting  character,  the  sinking  fund  reserve 
may  be  quite  safely  applied  in  reduction  of  the  book  value 
thereof,  or  it  may  with  equal  propriety  be  applied  in  reduc- 
tion of  the  book  value  of  goodwill  or  patents. 

It  is  important  to  note  that  there  is  no  relation  what- 
ever between  the  amount  of  sinking  fund  instalment  and 
the  annual  depreciation  charge;  it  is  therefore  still  neces- 
sary to  calculate  the  latter  on  the  usual  principle,  and 
then  to  consider  to  what  extent  the  sinking  fund  instal- 
ment may  be  properly  considered  as  available  to  meet  this 
provision.  The  considerations  here  involved  will  appear 
more  clearly  in  dealing  with  the  subject  of  depreciation. 

(7)  Other  Provisions  or  Appropriations 

In  considering  reserves  it  is  important  to  distinguish 
between  voluntary  reserves  and  necessary  reserves;  the 
former  being  mere  allocations  of  surplus  while  the  latter 
are  either  an  actual  liability  or  a  deduction  from  the 
book  value  of  an  asset. 

No  balance  sheet  can  set  forth  clearly  the  true  position 
of  afifairs  unless  all  reserves  have  been  provided  which,  at 
the  time  of  the  preparation  of  the  balance  sheet,  may  be 
found  necessary  for  contingencies  that  have  actually  arisen 
at  or  prior  to  the  date  to  which  the  balance  sheet  relates. 
Such  reserves  are: 

(i)   For  bad  debts  either  known,  or  estimated  on  the 
basis  of  past  experience. 

(2)  For  depreciation  of  plant. 

(3)  For  exhaustion  of  minerals. 

(4)  For  reduction  in  value  of  goods  on  hand  to  cost  or 

market  price. 


150    ACCOUNTING    PRACTICE    AND    PROCEDURE 

(5)  For  damage  claims  in  respect  of  events  which  have 

happened,  the  resulting  money  value  of  which 
can  only  be  estimated. 

(6)  For  expenses  incurred  but  not  definitely  ascertained 

in  money  value. 

The  first  four  of  these  should  in  preparing  the  balance 
sheet  be  deducted  from  the  assets  to  which  they  relate, 
while  the  last  two  would  be  included  as  current  liabilities. 

On  the  other  hand,  there  is  no  obligation  to  provide 
out  of  profits  for  contingencies  that  have  not  arisen  but 
may  arise  in  the  future.  Such  provisions  are  evidence  of 
prudent  foresight,  but  have  no  present  effect  upon  the 
surplus  as  a  whole,  and  if  made  they  should  be  set  up  as 
a  subdivision  of  the  general  surplus  account,  as  in  the 
form  of  balance  sheet  given  in  Chapter  II.  Such  volun- 
tary reserves,  in  addition  to  sinking  funds  already  dealt 
with,  would  consist  of : 

(a)  Provision    for    insurance   against    future   possible 

losses  from  fire,  etc.,  or  other  insurable  risks. 

(b)  Provision    for   losses   due   to   accidents   that   may 

occur  in  the  future. 

(c)  Provision  for  capital  outlays  representing  an  ap- 

plication of  profits  either  in  the  past  or  future  to 
the  creation  of  fixed  assets. 

(d)  Provision  for  equalizing  dividends  in  the  future; 

or, 

(e)  Provision  for  special  expenditures  to  be  incurred 

in  the  future. 

(8)   Secret  Reserves 

There  is  a  general  consensus  of  opinion  that  an  over- 
statement of  profits  knowingly  made  is  improper;  but  the 
opposite  proposition  as  to  an  understatement  of  profits 


BALANCE     SHEET     LIABILITIES  151 

has  SO  far  received  little  consideration,  and  yet  it  is  of 
considerable  importance.  Corporations  are  the  property 
of  the  stockholders;  and  therefore  primarily  anything 
which  the  stockholders  or  the  directors  elected  by  them 
may  approve,  may  be  considered  to  be  within  their  power 
to  decide  as  they  like,  provided  that  it  is  within  the  law; 
and  it  has  not  been  suggested  that  there  is  any  general 
law  which  would  prohibit  an  understatement  of  profits,  as 
it  would  undoubtedly  prohibit  an  overstatement.  But  in- 
asmuch as  the  stocks  of  the  majority  of  corporations  are 
quoted  on  the  stock  exchanges  throughout  the  country, 
the  corporation  is  in  some  sense  the  property  also  of  the 
public.  It  becomes,  therefore,  a  great  question  to  what 
extent  it  is  legitimate  or  proper  that  it  should  publish  a 
statement  of  its  earnings  or  its  position  which  materially 
underestimates  either;  though  it  is  clearly  within  the  dis- 
cretion of  the  managers  or  directors  to  make  reserves  to 
meet  possible  contingencies,  and  the  constitution  and  by- 
laws of  most  corporations  give  them  such  powers. 

Secret  reserves  may  take  several  forms,  as  writing  down 
to  a  comparatively  small  figure  valuable  assets,  providing 
excessive  depreciation,  providing  excessive  reserves  for 
bad  debts,  or  contingencies,  valuing  stocks  of  materials 
and  products  on  hand  at  values  largely  below  either  cost 
or  market,  or  including  special  reserves  for  future  con- 
tingencies under  the  head  of  accounts  payable.  Inasmuch 
as  the  majority  of  industrial  corporations  do  not  publish 
their  gross  earnings,  such  reserves  can  easily  be  made, 
and  are  made  continually  in  a  form  in  which  they  do  not 
appear  in  any  way  in  the  published  accounts,  and  are 
known  therefore  only  to  the  directors  and  managers. 

Each  case  must  be  judged  on  its  own  merits.  Where 
the  directors  or  managers  have  exercised  a  wise  discretion 
in  providing  in  advance  for  contingent  losses,  incident  to 


152    ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  nature  of  the  business,  which  cannot,  from  a  reason- 
able point  of  view,  be  considered  as  in  excess  of  the 
amounts  which  a  wise  foresight  would  provide,  it  would 
seem  that  no  exception  should  be  taken  to  the  undis- 
closed provision  thereof.  This  would  apply  particularly 
to  cases  in  which  the  business  conducted  was  of  a  fluctu- 
ating or  speculative  character,  or  in  which  its  success  was 
largely  dependent  on  the  maintenance  of  very  high  credit, 
such  as  a  bank.  Reserves  in  such  cases  may  well  be  larger 
than  in  others  where  such  conditions  do  not  exist,  pro- 
vided that  they  are  made  on  the  same  sort  of  basis  con- 
tinuously and  not  merely  spasmodically.  In  all  such 
cases  the  sudden  disclosure  of  heavy  deficits  or  losses 
which  are  clearly  incident  to  the  nature  of  the  business 
but  only  occur  at  irregular  intervals,  may  easily  be  dis- 
astrous to  the  interests  of  the  stockholders  by  unduly  de- 
pressing the  market  price  of  the  capital  stock,  and  it 
would  seem  to  be  not  only  the  right  but  the  duty  of 
directors  to  protect  them  against  such  contingencies  by 
making  ample  secret  reserves  when  profits  permit.  Where, 
however,  reserv^es  are  made  largely  in  excess  of  any  possi- 
ble contmgencies,  the  amounts  provided  should  be  dis- 
closed in  the  Profit  and  Loss  account  and  probably  also 
in  the  balance  sheet,  so  that  all  those  interested  may  be 
in  a  position  to  form  a  reasonably  correct  opinion  as  to 
the  financial  position.  So  far  as  the  majority  of  cor- 
porations and  businesses  are  concerned,  publicity  in  such 
matters  is  undoubtedly  most  desirable;  and  all  reserves 
to  meet  contingencies  which  may  occur  in  the  future,  but 
have  not  yet  occurred,  should  be  fully  disclosed. 


CHAPTER  VII 

REPAIRS,  RENEWALS,  DEPRECIATION,  AND 
NEW  CONSTRUCTION 

In  order  to  insure  a  correct  statement  of  the  earnings 
and  position  of  any  business,  it  is  essential  either  that  its 
property  should  be  fully  maintained  at  the  same  standard 
as  at  the  date  of  acquisition,  or  that  proper  provision  should 
be  made  for  any  falling  off  from  that  standard.  A  little 
reflection  will  show  that  the  first  alternative  is  impossible  in 
the  case  of  a  new  property.  After  a  plant  has,  within  a 
short  period  of  its  original  construction,  reached  its  state 
of  fullest  efficiency,  it  is  continually  wearing  out;  and  even 
though  it  may  be  a  long  period  before  the  wear  and  tear 
reaches  such  proportions  that  actual  renewal  expenditures 
are  either  necessary  or  desirable,  yet  the  shrinkage  in  value 
resulting  therefrom  is  going  on  all  the  time,  and  must  be 
reflected  in  the  accounts.  The  provisions  necessary  either  to 
maintain  the  property  values,  or  to  compensate  for  any 
falling  off  from  the  original  standard,  consist  of  repairs, 
renewals,  and  depreciation,  the  latter  including  both  that 
due  to  wear  and  tear  and  that  due  to  obsolescence. 

By  reason  of  the  fact  that  frequently  the  property  is 
maintained  by  expenditures  on  additional  construction  to 
take  the  place  of  that  worn  out  or  abandoned,  the  considera- 
tion of  construction  is  also  involved  in  that  of  maintenance ; 
and  further  light  may  be  thrown  on  the  whole  question 
by  first  considering  which  class  of  expenditures  may  be 

153 


154    ACCOUNTING    PRACTICE    AND    PROCEDURE 

legitimately  added  to  capital  account,  the  natural  inference 
being  then  drawn  that  all  other  expenditures  must  be  pro- 
vided for  in  some  form  out  of  income. 

( I )  Property  Expenditures 
Classification 

Expenditures  on  property  may  be  broadly  divided  into : 

(a)  Actual  additions  to  the  property,  such  as  new  build- 
ings, new  engines  or  new  tools,  which  did  not  exist  before, 
or  additions  to  existing  articles  of  this  class.  All  such 
expenditure  would  be  at  once  admitted  as  a  proper  charge 
to  Capital  account. 

(b)  Alterations  to  capital  assets  resulting  in  increased 
capacity  or  reduction  in  expenses  of  operation,  or  both.  The 
treatment  of  this  class  of  expenditure  must  depend  largely  on 
the  circumstances  surrounding  each  case.  As  a  rule  that 
portion  of  the  expenditure  which  has  resulted  in  additional 
property  or  increased  capacity  may  be  properly  charged  to 
Capital  account,  while  the  portion  representing  reconstruc- 
tion of  a  plant  to  keep  pace  with  modern  operating  condi- 
tions, to  prevent  deterioration  in  the  effective  operating 
value,  or  to  offset  the  increase  in  costs  due  to  the  rise  in  the 
price  of  labor  and  material,  would  usually  be  chargeable  to 
Income  account  either  directly  or  through  the  renewal  or 
depreciation  accounts,  discussed  later. 

(c)  Expenditures  necessary  to  rehabilitate  and  restore  to 
a  normal  working  efficiency  a  property  which  has  been  pur- 
chased in  a  depreciated  condition.  These  may  include  out- 
lays which  under  normal  conditions  could  only  be  considered 
income  charges,  but  under  the  special  conditions  existing 
may  properly  be  treated  as  capital. 

(d)  Finally,  we  have  ordinary  replacements,  repairs  and 
renewals,  recurrent  either  at  long  or  short  intervals,  and 
resulting  neither   in  increased   capacity  nor  in  saving  in 


REPAIRS,     RENEWALS,     DEPRECIATION  1 55 

Operating  expenses.  Such  would  always  be  a  charge  against 
profits,  either  through  the  depreciation  account  or  direct, 
according  to  the  nature  of  the  outlay. 

In  one  sense,  it  may  be  said  that  all  expenditures  on 
assets  which  deteriorate  from  the  wear  and  tear  incidental 
to  operating,  are  in  the  nature  of  deferred  charges  to  oper- 
ating, and  must  be  written  off  completely  during  some  fixed 
term  applicable  to  the  particular  plant  under  consideration. 
This  view  may  be  admitted  as  a  true  one  of  individual 
machine  units ;  but  a  whole  plant  remains  in  existence  over 
long  terms  of  years  as  a  complete  entity,  and  to  all  intents 
and  purposes — so  far  as  waste  due  to  operating  is  concerned 
— may  be  better  considered  as  a  permanent  investment, 
which  must  be  kept  in  good  and  efficient  going  order  by 
means  of  expenditures  on  repairs,  renewals,  and  depreciation. 

Reconstruction  and  Improvements 

It  may  frequently  happen,  as  for  instance  in  large  recon- 
struction and  improvement  works  resulting  in  some 
partially  new  structures,  and  in  others  substantially  repaired 
and  renewed,  that  it  is  a  difficult  matter  to  determine  what 
proportion  of  the  charges  should  be  made  to  income  and 
what  to  capital.  The  proper  rule  is  that  an  amount  which 
will  fairly  represent  either  the  original  cost  or  the  value 
now  (according  to  the  general  method  adopted*)  of  the 
property  abandoned  together  with  the  cost  of  all  alterations, 
shall  be  charged  to  Income  account  or  to  credit  accounts 
created  out  of  income ;  the  excess  may  fairly  be  capitalized. 

Interest  and  Overhead  Charges  in  Capital  Outlay 

A  difficult  problem  in  the  proper  determination  of  the 
cost  of  additions  and  improvements  to  property  is  involved 
in  the  matter  of  overhead  charges  and  interest.  In  the  case 
of  expenditures  chargeable  to  profits  this  question  is  of 

*See  page  159- 


156    ACCOUNTING    PRACTICE    AND    PROCEDURE 

little  importance,  because  the  credits  to  profits  in  respect  of 
such  charges  are  offset  by  the  debits  contained  in  the  charges. 
In  the  case  of  capital  expenditures,  however,  any  arbitrary 
addition  for  overhead  charges  and  interest  involves  a  credit 
to  and  increase  in  profits  corresponding  to  the  addition  to 
capital  expenditures.  In  a  going  concern  a  conservative 
course  is  generally  adopted,  and  no  charge  is  made  beyond 
the  labor  and  material  cost  for  expenditures  of  moderate 
amount  on  additions  to  the  property ;  but,  on  the  other  hand, 
if  a  new  and  distinct  plant  were  in  course  of  construction, 
and  producing  no  earnings  from  operation,  the  whole  of  the 
administration  expenses  and  the  interest  paid  on  loans  raised 
for  thi§  special  purpose  would  be  charged  to  construction 
account;  and  rightly  so,  being  necessary  elements  of  com- 
pleting the  work. 

This  at  once  suggests  the  argument  that  what  is  reason- 
able and  proper  in  the  latter  case  should  also  be  reason- 
able and  proper  in  the  former.  The  safe  rule  is,  however, 
that  no  charges  should  be  made  to  construction  for  overhead 
expenses  which  would  have  been  equally  incurred  if  there 
had  been  no  such  construction,  and  would  in  that  case  have 
been  charged  against  profits ;  but  that,  if  special  loans  have 
been  raised  to  provide  funds  for  construction  purposes,  or  a 
special  staff  of  employees  maintained  for  this  sole  purpose, 
the  interest  paid  on  such  loans  and  the  salaries  of  the  special 
staff  may  properly  be  charged  to  construction  account  until 
the  work  under  construction  is  in  effective  operation.  Any 
other  method  might  result  in  the  creation  of  fictitious  profits, 
which  could  not  be  realized  as  long  as  the  property  was 
operated,  and  might  never  be  realized  on  its  ultimate  sale. 

Profits  on  Construction  Work  Not  Permissible 

Managers  of  the  operating  departments  of  a  factory 
frequently  claim  that  they  should  be  allowed  to  charge  a 


REPAIRS,    RENEWALS,     DEPRECIATION  157 

profit  on  construction  work  carried  out  for  their  own  mills, 
on  the  ground  that,  if  the  work  were  done  outside,  they 
would  have  to  pay  a  profit,  and  at  the  same  time  would  set 
free  their  own  facilities  to  carry  out  additional  work  at  a 
profit  for  outside  customers ;  and  they  even  go  so  far  as  to 
say  that,  if  they  can  not  charge  a  profit  on  construction  work 
so  carried  o^t,  they  will  in  future  have  the  work  done  by 
outside  contractors.  It  must  be  admitted  that  this  is  a 
plausible  argument,  but  a  little  further  consideration  will 
show  that  it  is  fallacious. 

There  is  here  a  confusion  between  a  profit  and  a  saving. 
The  reason  that  a  concern  undertakes  its  own  construction 
work  in  place  of  letting  outside  contracts  therefor,  is  that  it 
can  by  that  means  effect  a  saving  in  its  expenditure  by  taking 
advantage  of  its  own  capital  and  facilities  to  carry  out  the 
work,  instead  of  using  the  organization  and  the  capital  of 
others,  upon  which  it  would  have  to  pay  a  profit.  The  saving 
so  effected  is  of  considerable  advantage,  in  that  it  reduces 
the  amount  of  capital  invested,  and  future  earnings  will 
represent  a  larger  return  on  the  investment.  Moreover,  it 
is  seldom  true  in  a  well-managed  going  concern  that  the  use 
of  its  facilities  for  construction  expenditure  involves  giving 
up  profitable  work  for  outsiders,  which  would  otherwise  have 
been  undertaken ;  the  situation  will  have  been  foreseen  and 
arrangements  made  so  that  its  organization  may,  almost 
automatically,  expand  sufficiently  to  provide  for  any  increase 
in  its  operations  which  is  likely  to  be  thrown  upon  it.  In  the 
contrary  case  it  would  be  difficult  to  find  justification  for 
increasing  costs  of  construction  because  of  the  lack  of  fore- 
sight of  the  management.  Moreover,  if  a  sum  be  added  to 
the  cost  of  construction  and  credited  to  Income  account,  to 
represent  the  profit  which  would  have  been  earned  by  the 
company  if  the  work  had  been  done  for  outsiders  instead  of 
for  itself,  this  profit  can  only  be  made  available  for  distri- 


158    ACCOUNTING    PRACTICE    AND    PROCEDURE 

bution  by  increasing  the  amount  of  capital  contributed  for 
new  construction  work ;  and  it  can  hardly  be  considered  good 
financial  policy  to  increase  indebtedness  or  take  in  new 
partners  merely  for  the  purpose  of  paying  dividends.  The 
only  sound  principle  that  can  be  adopted  is  to  charge  to 
construction  all  costs  and  expenses  which  are  directly 
attributable  to  that  construction,  together  with  a  fair  and 
moderate  proportion  of  necessary  indirect  expenses  and  of 
interest  actually  paid,  but  no  further  amount  to  represent 
profit. 

It  should  be  noted  that  in  England  the  Companies  (Con- 
solidation) Act,  1908,*  now  provides  that  when  any  shares 
of  a  company  are  issued  to  provide  money  for  construction 
purposes,  the  company  may,  subject  to  certain  regulations 
and  to  the  approval  of  the  Board  of  Trade  (a  government 
department),  pay  interest  on  such  shares  to  the  stockholders 
at  a  rate  not  exceeding  4  per  cent  per  annum  during  the 
construction  period;  and  that  the  interest  so  paid  may  be 
added  to  and  form  part  of  the  cost  of  construction.  This 
provision  does  not  permit  of  the  addition  to  construction 
cost  of  any  interest  which  is  not  actually  paid  out  in  cash. 

So  far  this  question  has  been  considered  in  reference  to 
its  bearing  on  the  determination  of  profits.  There  is,  how- 
ever, the  other  aspect  of  its  bearing  on  values.  If  an  asset  is 
created  by  construction  without  including  in  the  charge 
all  the  elements  which  an  outside  contractor  would  charge, 
the  value  based  upon  market  prices  will  clearly  be  low. 
The  saving  so  effected  is  of  undoubted  benefit,  in  that  less 
capital  has  been  employed  upon  which  profit  has  to  be 
earned,  but  the  asset  value  is  understated.  On  the  ground 
already  stated  that  no  profits  should  be  made  out  of  construc- 
tion, this  difference  in  value  cannot  be  considered  as  a  profit 
arising  out  of  operations ;  but  there  can  be  no  objection  to 
treating   it   as   surplus   appropriated   to  capital  purposes, 

*See  Appendix  IV. 


REPAIRS,    RENEWALS,    DEPRECIATION  1 59 

provided  always  that  the  total  book  value  of  all  assets 
together  is  not  in  excess  of  actual  value. 

(2)  Maintenance  Expenditures 

•  Turning-  now  to  the  consideration  of  maintenance 
expenditures,  it  is  apparent  at  the  outset  that  there  are  two 
distinct  theories  upon  which  this  problem  can  be  properly 
considered. 

Under  the  first  method,  capital  is  considered  to  have 
been  invested,  once  for  all,  in  property  which  is  permanent 
and  must  be  kept  up  at  the  expense  of  income,  no  additions 
being  made  to  the  capital  account  except  for  entirely  new 
and  additional  property,  and  all  expenditures  on  maintain- 
ing or  replacing  the  existing  property,  irrespective  of  the 
relative  values  at  the  time  of  construction  and  of  replace- 
ment, being  charged  to  Income  account. 

Under  the  second  method,  each  unit  of  property  is  fol- 
lowed from  its  construction  to  its  removal  or  destruction ; 
upon  abandonment  its  original  cost  value  is  written  off  to 
income  and  the  cost  of  the  new  structure  which  takes  its 
place  is  charged  to  capital. 

Under  the  first  method  changes  in  price  levels  are 
reflected  in  the  Income  account,  while  under  the  second 
method  they  are  reflected  in  Capital  account.  Over  a  long 
period  of  years,  where  prices  are  rising  and  falling  alter- 
nately, there  will  be  little  difference  between  the  results  of 
the  two  methods  in  this  respect,  provided  that  one  or  the 
other  is  consistently  followed  throughout  for  each  class  of 
assets ;  and  provided  that  proper  provision  is  made  under  the 
first  method  for  dealing  with  property  abandoned  and  not 
replaced.  If,  however,  prices  are  continuously  rising  or  con- 
tinuously falling,  the  first  method  will  give  greater  or 
smaller  charges,  respectively,  to  Income  account,  than  the 
second,  and  the  latter  will  tend  to  keep  the  Capital  account 


l6o    ACCOUNTING    PRACTICE    AND    PROCEDURE 

nearer  to  the  current  level  of  prices  than  the  former.  The 
first  method  perhaps  brings  out  more  clearly  the  problem 
with  which  operating  officials  have  to  deal — namely,  the 
maintenance  of  the  property  entrusted  to-  them  for  the 
purposes  of  operation — and  avoids  the  confusion  which 
frequently  arises  between  depreciation  due  to  wear  and  tear 
(which  sooner  or  later  will  have  to  be  made  good  by  cash 
expenditures),  and  appreciation  arising  from  circumstances 
entirely  outside  the  operations,  which  can  never  be  realized 
so  long  as  operations  continue,  and  which  should  be  dealt 
with  as  a  separate  question. 

Treatment  of  Maintenance  Expenditures  by  Railroads 

The  two  methods  are  well  illustrated  by  the  present  prac- 
tice of  railroads  where  both  are  in  use  for  different  portions 
of  the  property.  It  should  be  noted  that  from  the  earliest 
days  the  treatment  by  railroad  companies  of  renewals, 
replacements,  and  depreciation,  has  differed  from  the  prac- 
tice general  among  commercial  concerns.  Prior  to  the 
revision  of  the  classification  of  railroad  accounts  by  the 
Interstate  Commerce  Commission  beginning  in  1907,  rail- 
road accounts  were  kept  on  the  theory  that  the  capital  and 
revenue  accounts  were  distinct,  and  that  the  only  charges 
to  be  made  to  the  latter  should  be  for  the  cost  of  replacing 
property  as  and  when  replacements  were  made,  no  provision 
whatever  being  made  for  property  abandoned.  This  differ- 
ence in  treatment  was  fostered  in  England  by  the  legislative 
enactments  in  regard  to  railroads;  but  from  an  accounting 
standpoint  it  was  never  regarded  as  resting  on  very  solid 
ground,  and  from  a  financial  standpoint  its  results  did  not 
prove  satisfactory.  After  the  panic  in  1893  ^^^  the  numer- 
ous railroad  reorganizations  which  followed,  whilst  the 
methods  above  noted  were  continued,  their  harmful  effects 
were  largely  counterbalanced  by  the  practice,  which  became 


REPAIRS,    RENEWALS,    DEPRECIATION         l6l 

general,  of  charging  to  income  or  profit  and  loss  large  sums 
which  might  properly  have  been  capitalized. 

In  the  classification  prescribed  by  the  Interstate  Com- 
merce Commission,  provision  is  made  for  writing  off  prop- 
erty abandoned,  whether  replaced  or  not.  When  equip- 
ment is  retired  the  ledger  value  of  each  unit,  which  in  the 
ordinary  case  is  the  original  cost  of  the  unit  to  the  com- 
pany, is  required  to  be  credited  to  Capital  account,  and  this 
value,  less  salvage,  is  required  to  be  provided  for  out  of 
current  or  accumulated  income,  except  to  the  extent  that 
a  provision  has  already  been  made  through  depreciation 
charges.  In  allocating  the  charges  between  current  and 
accumulated  income,  the  amount  of  depreciation  up  to  July 
I,  1907  (when  provisions  for  depreciation  were  first  pre- 
scribed), not  previously  written  off  or  provided  for,  is  to 
be  charged  to  Profit  and  Loss  account,  and  the  remainder 
to  operating  expenses.  In  this  procedure  the  second  method 
described  above  is  followed,  and  not  only  increased  capacity, 
but  also  any  variation  in  the  price  of  equipment,  is  carried 
to  Capital  account. 

In  the  case  of  other  replacements  of  entire  units  of 
property,  except  units  of  minor  importance,  the  same  basis 
is  now  prescribed  as  for  equipment.  Formerly  it  was  re- 
quired that  cost  of  renewal  of  the  property  retired,  on  the 
basis  of  present  day  prices  (less  salvage)  should  be  charged 
to  operating  expenses,  but  the  present  rule  was  substituted 
as  from  July  i,  19 14.  Here  the  first  method  has  been  sup- 
planted by  the  second. 

In  the  case  of  "betterments,"  wnich  are  described  as 
substitutions  of  superior  parts  for  inferior  parts,  and  in  the 
case  of  replacements  of  entire  units  when  they  are  of  minor 
importance,  it  is  required  that  the  cost  of  current  prices  of 
new  parts  of  the  kind  retired  (less  salvage)  shall  be  charged 
to  operating  expenses.      Herein  changes   in  the  physical 


l62         ACCOUNTING  PRACTICE  AND   PROCEDURE 

character  of  the  property  are  reflected  in  Capital  account, 
but  changes  in  prices  are  not;  the  first  method  is  still  fol- 
lowed. 

In  the  case  of  property  (other  than  equipment)  aban- 
doned and  not  replaced,  its  ledger  value,  less  salvage,  is 
required  to  be  charged  to  Profit  and  Loss  account. 

In  the  classification  effective  July  i,  19 14,  the  Interstate 
Commerce  Commission  made  provision  for  depreciation  of 
fixed  improvements  as  well  as  of  equipment  "for  the  pur- 
pose of  creating  reserves  which  will  meet  or  reduce  the 
amounts  otherwise  chargeable,  as  may  be  appropriate,  to 
operating  expense  or  to  profit  and  loss  accounts  to  cover 
property  retired."  The  use  of  the  depreciation  accounts 
was  made  optional  with  the  carrier,  but  if  they  were  em- 
ployed the  charges  were  to  be  "based  in  each  instance  upon 
the  percentage  of  original  cost  (estimated  if  not  known), 
ledger  value,  or  purchase  price  of  the  property  determined 
to  be  equitable  by  the  carrier's  experience  and  best  sources 
of  information  as  to  the  actual  current  loss  from  depre- 
ciation." When  such  reserves  are  carried,  the  charge  to 
operating  expense  or  profit  and  loss  accounts  in  the  event 
of  a  retirement  are  reduced  by  the  amount  that  has  been 
set  up  in  the  reserve  specifically  in  respect  of  the  retired  unit. 
While  the  special  conditions  on  railroads  render  the  failure 
to  provide  depreciation  more  defensible  than  in  the  case  of 
most  undertakings,  the  trend  is  worthy  of  note. 

Classification  of  Maintenance  Expenditures 

Having  disposed  of  these  important  questions,  the 
methods  of  providing  for  the  maintenance  of  property  may 
be  considered.    Maintenance  expenditures  consist  of: 

(i)  Repairs. 

(2)  Renewals. 

(3)  Improvements  which  cannot  be  capitalized. 


REPAIRS,    RENEWALS,     DEPRECIATION  163 

There  are  also  improvements  which  might  legitimately 
be  capitalized,  but  which  conservative  policy  desires  to  pro- 
vide for  out  of  profits ;  this  class  may  be  at  once  disposed  of 
inasmuch  as,  being  legitimate  capital,  they  should  be  treated 
as  such;  charged  to  capital,  and  credited  to  profits  appro- 
priated for  capital  purposes. 

The  first  class  of  expenditures  will  occur  continuously 
and  will  usually  be  charged  against  Income  as  and  when 
incurred,  although  occasionally  repairs  and  renewals  are 
grouped  together  and  treated  on  the  basis  now  to  be  de- 
scribed for  the  latter.  It  is  difficult  to  draw  a  hard  and 
fast  line  between  these  three  classes,  as  one  naturally  merges 
into  the  other,  but  the  following  has  in  practice  been  found 
satisfactory  when  applied  with  reasonable  intelligence  to 
doubtful  items. 

(i)  Repairs.  This  should  include  all  current  expendi- 
tures recurring  from  day  to  day  and  from  month  to  month 
on  the  general  upkeep  of  the  existing  property  without  the 
renewal  of  any  substantial  part  thereof,  and  generally  all 
periodical  repairs  which  are  necessarily  undertaken  within, 
say,  one  year. 

(This  caption  will,  of  course,  include  certain  renewals  of 
small  parts,  etc.,  such  as  would  be  necessary  to  continue  the 
useful  life  of  any  unit  of  building,  plant  or  machinery  over 
the  estimated  period  of  its  life.) 

(2)  Renewals.  This  should  include  all  expenditures 
incurred  in  renewing,  in  whole  or  in  part,  any  unit  of  build- 
ing, plant  or  machinery,  which  tend  to  extend  its  useful  life 
beyond  the  average  term.  These  expenditures  would  in 
general  be  those  which  would  only  occur  at  long  intervals 
of  two  or  three  years,  and  whose  effect  would  last  for  a 
number  of  years  afterward. 

(3)  Improvements.  This  should  include  any  expendi- 
tures made  upon  existing  buildings,  plant  and  machinery. 


l64    ACCOUNTING    PRACTICE    AND    PROCEDURE 

other  than  those  covered  hy  the  terms  "Repairs"  and  "Re- 
newals." 

(3)   Renewals  and  Depreciation 

General  Considerations 

In  practice  it  is  difficult,  and  perhaps  hardly  necessary,  to 
draw  any  hard  and  fast  line  between  renewals  and  improve- 
ments. Renewals  of  plant  generally  carry  with  them  some 
measure  of  improvement,  and  while  for  management  pur- 
poses it  is  as  well  to  distinguish  between  the  two  classes  of 
expenditures,  both  of  them  must  be  considered  as  making 
good  or  arresting  depreciation  which  has  taken  or  might 
take  place ;  and  for  this  purpose  provisions  for  such  improve- 
ments as  can  not  be  charged  to  Capital  account  will,  as  a  rule, 
be  made  out  of  the  fund  provided  to  take  care  of  renewals 
and  depreciation  as  now  to  be  described. 

Renewal  expenditures  being  incurred  only  periodically 
— and  in  the  case  of  a  new  plant  only  after  a  period  of  several 
years — while  the  wear  and  tear  goes  on  continually,  must 
be  provided  for  each  year  by  an  estimated  charge  based  on 
the  best  available  information  as  to  the  life  and  character 
of  the  particular  plant.  Involved  therein  is  the  ultimate 
replacement  of  each  separate  unit  of  plant  when,  by  reason 
of  excessive  wear  and  tear,  want  of  efficiency,  or  obso- 
lescence, it  ceases  to  be  economical  to  operate  it.  There  is 
some  difference  of  opinion  as  to  whether  depreciation  due 
to  obsolescence  on  a  large  scale — for  instance,  as  in  the  con- 
version of  horse  street  railways  into  cable  or  electric  rail- 
ways, or  of  an  ordinary  steam  electric  generating  plant  into 
a  steam  or  water  turbine  plant — should  necessarily  be  met 
out  of  earnings,  on  the  ground  that  the  savings  in  future  cost 
of  operation  will  pay  for  the  charge.  This,  however,  seem? 
to  be  an  argument  in  favor  of  providing  for  the  loss  on  the 
change  out  of  future  rather  than  past  earnings,  for  there 


REPAIRS,    RENEWALS,     DEPRECIATION  165 

can  be  no  doubt  that  certain  property  has  ceased  to  exist. 
The  result  of  such  a  poHcy  was  well  seen  in  the  case  of  the 
Metropolitan  Street  Railway  system  in  New  York,  which, 
largely  for  want  of  proper  depreciation  charges,  was  prac- 
tically ruined  and  forced  into  the  hands  of  a  receiver;  the 
reorganization  involving  a  considerable  reduction  in  the 
capital  values  of  the  property.  Another  objection  to  the 
postponement  or  abandonment  of  charges  for  accruing 
renewals  and  depreciation  is  to  be  found  in  the  lessened 
operating  costs  and  greater  profits  thereby  shown,  which, 
in  these  days  of  rate  regulation  of  public  service  companies, 
must,  if  continued,  inevitably  lead  to  demands  for  reductions 
in  rates.  If  an  insufficient  provision  has  been  made  in  the 
past,  and  the  resulting  profits  have  been  distributed  in  divi- 
dends at  a  full  and  reasonable,  or  even  excessive  rate,  it  is 
difficult  afterwards  to  maintain,  as  an  argument  against  rate 
reductions,  that  the  provisions  for  depreciation,  etc.,  have 
been  insufficient  in  the  past  and  must  be  largely  increased  in 
the  future.  In  the  case  of  Knoxville  v.  Knoxville  Water 
Company,  the  United  States  Supreme  Court  held  that  the 
water  company,  having  failed  to  provide  for  depreciation  in 
the  past,  could  not,  therefore,  claim  a  value  for  its  property 
on  the  basis  of  cost  to  reproduce,  without  deduction  for 
depreciation. 

The  only  sound  principle  would  seem  to  be  that  no  profit 
can  be  properly  said  to  have  been  earned  until  full  provision 
has  been  made  on  the  best  available  data  both  for  accruing 
renewals  and  for  depreciation  due  to  obsolescence  or  other 
causes;  and,  if  such  full  provision  is  not  made,  it  should  be 
clearly  understood  that  eventually,  except  for  possible  appre- 
ciation of  property  due  to  entirely  extraneous  causes,  part 
of  the  capital  will  be  lost,  or  will  have  been  distributed  in 
dividends. 

It  remains  to  consider  how  such  provisions  for  renewals 


I66    ACCOUNTING    PRACTICE    AND    PROCEDURE 

and  depreciation  should  be  dealt  with.  In  the  early  life^of 
a  new  plant,  there  will  be  little  or  no  expenditure  upon 
renewals,  and  a  consequent  accumulation  to  the  credit  of 
Depreciation  account.  After  some  years  renewal  expendi- 
tures to  be  charged  against  this  account  will  increase,  but 
there  should  always  remain,  if  the  provisions  have  been 
sufficient,  a  credit  balance  which  will  represent  the  difference 
between  original  cost  and  average  efficient  value;  i.  e,,  the 
value  below  which  the  plant  cannot  be  allowed  to  fall  with- 
out becoming  inefficient.  It  might  at  first  be  thought  that 
the  factor  of  obsolescence  would  not  begin  to  operate  until  an 
even  later  period,  and  in  some  extreme  cases  this  may  be 
true;  but  as  a  rule,  owing  to  the  continuous  progress  of 
science  and  invention,  obsolescence  will  be  as  continuous  as 
renewals,  and  after  an  increase  of  the  Depreciation  account 
to  a  figure  which  cannot  be  definitely  stated  but  may,  for 
the  sake  of  example,  be  put  at  from  25  to  33  1/3  per  cent 
of  the  original  plant  cost,  expenditures  will,  on  the  average 
of  a  few  years,  keep  pace  with  the  addition  to  the  Deprecia- 
tion account  and  there  should  be  no  further  accumulation. 

The  charges  to  the  Depreciation  account  will  vary  accord- 
ing to  which  of  the  methods  of  maintaining  the  Capital 
account — as  fully  defined  on  page  159 — is  adopted.  Under 
the  first  method  all  expenditures,  both  for  renewals  and 
replacements,  will  be  charged  to  Depreciation  account,  no 
charge  will  be  made  for  property  abandoned  and  replaced, 
but  a  charge  should  be  made  for  property  abandoned  but 
not  replaced.  Under  the  second  method  all  expenditures 
on  renewals,  as  above  defined,  will  be  charged  against  the 
Depreciation  account,  as  well  as  the  book  value  of  all  prop- 
erty abandoned  and  not  replaced,  the  charge  to  operating 
expenses  consisting  of  (i)  repairs  as  defined  above,  and  (2) 
depreciation;  while  the  cost  of  new  property,  to  replace 


REPAIRS,    RENEWALS,     DEPRECIATION  167 

that  abandoned  and  charged  to  the  Depreciation  account, 
will  be  charged  to  Capital  account. 

(4)  Methods  of  Providing  for  Depreciation 

One,  and  the  most  simple,  method  of  providing  for  depre- 
ciation, for  which  little  or  no  justification  exists,  is  by  the 
charge  of  arbitrary  sums  from  time  to  time,  either  to  income 
or  to  profit  and  loss,  as  earnings  and  surplus  permit,  and 
upon  no  definite  basis. 

Any  scientific  system  necessitates  in  the  first  place  a 
detailed  plant  inventory,  divided  into  groups  according  to 
the  estimated  life,  assuming  ordinary  repairs  to  be  made. 
From  these  data  can  be  calculated  the  amount  which  must 
be  provided  in  a  definite  number  of  years  to  make  up  the 
difference  between  cost  and  scrap  values  at  the  time  when 
the  unit  may  be  expected,  in  the  ordinary  course  of  events, 
to  become  obsolete.  It  must  be  noted  that  all  such  calcula- 
tions are  purely  estimates,  based  on  past  experiences  so  far 
as  available;  and  periodical  revisions  of  all  the  elements 
involved  are  necessary  if  the  result  is  to  work  out  with  any 
degree  of  accuracy. 

There  are  four  methods  by  which  the  amount  required 
for  depreciation  as  thus  ascertained  may  be  provided. 

(i)  The  annuity  method;  i.  e.,  setting  aside  each  year 
a  fixed  annual  sum  which,  accumulated  at  compound  interest 
at  some  assumed  rate,  will  provide  the  amount  required 
at  the  end  of  the  agreed  Hfe. 

(2)  The  straight  line  method,  by  which  an  equal  propor- 
tionate part  is  charged  each  year;  i.  e.,  on  an  outlay  of 
$1,000,000  with  a  life  of  twenty  years,  and  a  scrap  value  of 
$300,000,  the  annual  charge  would  be  $35,000. 

(3)  The  diminishing  balance  method,  under  which,  in 
the  case  of  an  outlay  of  $1,000,000  with  a  life  of  twenty 


l68    ACCOUNTING    PRACTICE    AND    PROCEDURE 

years  and  a  scrap  value  of  $300,000,  an  annual  sum  of  6 
per  cent  on  the  balance  at  the  beginning-  of  each  year — after 
deducting  the  depreciation  of  the  previous  year — would  be 
provided. 

(4)  A  combination  of  the  first  two  methods,  by  which 
an  annuity  is  provided  for  so  much  of  the  depreciation  as 
represents  the  drop  from  new  to  normally  efficient  value, 
and  the  straight  line  method  is  provided  for  the  balance, 
which  represents  renewal  expenditures  which  will  have  to 
be  incurred. 

Annuity  Method 

Objections  to  the  annuity  method  are  that  it  does  not 
take  into  account  that  expenditures  are  continually  being 
incurred  to  make  good  the  depreciation  accrued;  that  these 
expenditures  must  be  taken  out  of  the  fund;  consequently 
that  the  fund  will  not  remain  intact  during  even  a  small 
part  of  the  assumed  term  and  that  it  cannot  be  accumulated 
to  the  estimated  required  amount  at  the  end  of  the  term. 
Furthermore,  by  the  addition  of  interest  it  becomes  an 
increasing  charge  against  profits  each  year,  unless,  which  is 
unlikely,  the  fund  is  vSpecifically  invested;  and  it  would  be 
difficult  for  the  owners  to  resist  the  temptation  to  reduce  the 
annual  contributions  in  later  years  if  profits  were  insuffi- 
cient for  their  needs.  In  fact  this  sinking  fund  method  does 
not  take  into  account  the  essential  character  of  a  depreciation 
fund — viz. :  a  fund  set  aside  not  for  the  sole  purpose  of 
providing  the  value  of  the  plant  at  the  end  of  a  term,  but  for 
the  much  more  important  purpose  of  keeping  the  plant  up 
to  the  highest  standard  of  efficiency,  and  leaving  it  at  that 
standard  at  the  end  of  the  term  by  continuous  expenditures 
during  the  term. 

A  further  and  perhaps  even  greater  objection  to  the 
annuity  method  is  that  the  accumulations  are  small  in  the 


REPAIRS,    RENEWALS,    DEPRECIATION  169 

early  years  and  large  in  the  later  years,  whereas  the  actual 
fall  in  value  of  the  plant  will  usually  be  greatest  when  it  is 
new,  and  gradually  decrease  as  it  gets  older.  Consequently 
if  depreciation  is  provided  on  the  annuity  method,  even 
assuming  that  it  makes  good  the  whole  value  at  the  end  of 
an  assumed  term,  the  apparent  net  property  value  will, 
throughout  the  whole  of  that  term,  be  in  excess — and  in 
the  earlier  years  largely  in  excess — of  the  actual.  If  the 
property  changes  hands  on  a  valuation  basis,  the  amount  of 
depreciation  accumulated  on  the  annuity  basis  will  be  found 
entirely  inadequate. 

This  principle  came  up  for  consideration  in  the  purchase 
by  the  British  Government  of  the  National  Telephone  Com- 
pany in  Great  Britain.  The  company  claimed  a  depreciation 
deduction  on  the  annuity  basis,  while  the  government 
claimed  the  larger  deduction  provided  by  the  straight  line 
method.  After  hearing  testimony  on  the  subject  the  arbi- 
trator decided  in  favor  of  the  contention  of  the  government. 

Straight  Line  Method 

The  second,  or  straight  line  method,  has  been  found  on 
the  whole  the  most  satisfactory  for  a  going  concern  in  an 
average  condition,  but  for  a  new  plant  it  results  in  a  con- 
siderable accumulation  during  earlier  years  while  the  plant 
is  getting  down  to  its  average,  say  75  per  cent  condition, 
and  this  accumulation  will  in  all  probability  not  require  to 
be  expended  on  renewals. 

This  method  lends  itself  readily  to  a  sliding  scale  adjust- 
ment by  which,  as  is  proper,  the  provision  for  depreciation 
may  be  varied  in  accordance  with  the  amount  of  business 
done.  If  a  plant  is  working  at  only  50  per  cent  of  capacity 
and  is  thoroughly  maintained,  the  depreciation  due  to  wear 
and  tear  is  undoubtedly  much  less  than  if  it  were  working 
at  90  per  cent  of  capacity,  while  that  due  to  obsolescence  is 


lyo    ACCOUNTING    PRACTICE    AND    PROCEDURE 

unchanged.  On  this  basis,  for  any  particular  plant  a  sliding 
scale  of  depreciation,  according  to  used  capacity,  may  be 
prepared  which  will  be  just  to  both  present  and  future  own- 
ers, subject  always  to  the  necessarily  estimated  character  of 
all  depreciation  allowances. 

Diminishing  Balance  Method 

The  third  method  is  objectionable  in  that  it  ignores  to 
some  extent  the  spending  feature  of  the  fund.  When,  how- 
ever, renewals  made  are  added  to  capital  each  year  and  the 
depreciation  deducted,  and  the  depreciation  for  the  next  year 
is  calculated  on  the  balance  so  resulting,  this  method  would 
give  results  not  widely  different  from  the  second,  but  the 
rate  would  require  to  be  higher.  The  method  as  thus  carried 
out  is  confusing;  the  original  plant  value  is  lost  sight  of,  and 
the  accumulated  depreciation  unexpended  and  available  for 
future  renewals  is  not  clearly  shown. 

Combination  Method 

The  fourth  method  is  a  new  and  untried  one  which  has 
been  the  subject  of  some  discussion.  In  a  quite  new  plant 
it  has  the  advantage  of  diminishing  the  depreciation  charge 
in  the  earlier  years,  and,  provided  that  the  annual  instalments 
are  invested  outside  at  the  assumed  rate  and  maintained  as 
an  investment,  it  might  be  found  satisfactory.  If  the 
accumulations  are  invested  in  the  business,  the  charge  against 
profits  each  year  will  increase  so  that  eventually  it  will  be 
quite  a  serious  item  in  poor  years,  and  there  will  be  great 
temptation  to  draw  upon  it  in  favor  of  profits.  The  objec- 
tion already  noted  to  the  annuity  method,  viz. :  that  it  over- 
states property  values,  applies  equally  to  this  modified  form 
of  it,  for  the  depreciation  actually  accruing  within  the  early 
years  in  respect  of  the  fall  from  a  new  to  a  normally  efficient 
value,  will  only  be  provided  over  a  much  longer  term  and 
more  towards  the  end  of  that  term  than  at  the  beginning. 


REPAIRS.    RENEWALS,    DEPRECIATION  17I 

Treatment  of  Interest  on  Accumulated  Depreciation 

Any  of  the  methods  described  will  result  from  time  to 
time  in  the  accumulation  of  funds  in  excess  of  necessary 
or  economical  expenditures  for  renewals  and  replacements, 
and  this  accumulation  at  once  raises  the  question  of  interest. 
The  annuity  method  automatically  provides  for  this,  but  in 
the  other  methods  no  interest  charge  is  usually  considered. 
The  accumulated  funds  may  either  be  held  as  unexpended 
cash  balances  on  current  account  or  on  deposit,  or  may  be 
invested  in  outside  interest-bearing  securities,  or  may  be 
invested  in  the  undertaking — which  is  the  most  usual  case. 
Strictly  speaking,  interest  on  the  accumulated  funds  should 
go  in  reduction  of  the  annual  charge  to  operations  to  the 
extent  earned,  and  if  earned  in  the  business  this  credit  to 
operations  would  be  offset  by  a  debit  to  Income  account  as 
a  distribution  of  profits.  When  only  stockholders  are  inter- 
ested in  the  profits  there  is  no  necessity  to  take  into  consider- 
ation interest  on  these  balances,  as,  if  earned  from  outside 
sources,  it  forms  a  credit  to  Income  account,  and  if  not  so 
earned,  it  forms  part  of  the  profits  on  the  business  just  as 
does  surplus  not  distributed  in  dividends.  In  cases,  how- 
ever, where  outsiders  are  interested  in  operating  profits, 
such  as  in  profit-sharing  agreements  between  public  service 
corporations  and  a  state  or  city,  it  is  important  that  this 
principle  should  be  carried  out,  as  otherwise  the  stockholders 
alone  will  obtain  the  benefit  of  the  use  of  the  accumulated 
funds.  The  only  difficulty  is  as  to  the  rate  of  interest  to 
be  allowed;  in  theory  this  should  be  that  proportion  of  the 
net  profits — before  paying  interest  or  dividends — which  the 
accumulated  balance  of  the  depreciation  fund  bears  to  the 
total  capital  stock,  bonds,  surplus,  and  all  other  funds 
actually  invested  in  the  business;  or  the  rate  may  be  taken 
at  some  figure  on  the  average  approximating  thereto. 


172    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Exhaustion  of  Minerals 

Thus  far  depreciation  has  been  considered  in  respect  of 
assets  which  are  used  for  operations;  there  is  another  class 
of  depreciation  consisting  of  the  actual  consumption  of 
subsoil  products  which  reduces  the  original  property  value. 
This  is  more  generally  known  as  provision  for  exhaustion  of 
minerals. 

The  product  taken  out  of  the  land  becomes  stock  in 
trade  as  soon  as  it  is  extracted,  and  whatever  the  land  was 
worth  before  its  extraction,  it  is  clearly  worth  an  appreci- 
able amount  less  thereafter.  The  provision  to  be  made 
should  be  on  the  basis  of  the  quantity  extracted,  having 
regard  to  the  total  available,  and  to  the  realizable  value  of 
the  property  after  the  products  have  all  been  extracted.  The 
same  principle  would  also  apply  to  timber  lands  where  no 
provision  is  made  for  reforesting.  The  contention  is  some- 
times raised  that  no  provision  need  be  made  for  exhaustion 
of  subsoil  products  where  the  amount  known  to  be  in  a 
definite  tract  at  the  end  of  any  period  is  largely  in  excess 
of  that  which  had  been  discovered  at  the  beginning  of  the 
period.  This  argument  can  not,  however,  be  admitted  except 
as  a  reason  for  reducing  the  rate  to  be  provided.  As  a 
general  principle,  whatever  there  was  in  the  ground,  whether 
known  or  unknown,  has  been  reduced  during  the  period 
under  consideration  by  whatever  amount  has  been  extracted ; 
and  while  the  new  discoveries  may  be  accepted  as  reducing 
the  necessary  rate  of  provision  for  extinction  from,  say,  one 
dollar  to  one  cent  per  unit  of  quantity,  the  original  principle 
that  provision  must  be  made,  holds  good  on  the  smaller 
figure,  whatever  it  is.  It  may  be,  of  course,  that  the  pro- 
visions made  in  earlier  years  have  been  sufficient  to  cover  a 
number  of  future  years  on  the  basis,  from  the  commence- 
ment, of  the  rate  subsequently  found  to  be  sufficient  in  view 
of  the  new  discoveries;  and  in  this  case  there  would  be  no 


REPAIRS,    RENEWALS,    DEPRECIATION  173 

necessity  to  provide  further  for  extinction  until  the  total 
production  at  the  new  rate  is  equal  to  the  total  amount 
written  off. 

It  may  happen,  as  in  oil  fields  and  gold  mines,  that  it  is 
impossible  to  obtain  any  reasonable  basis  upon  which  to 
calculate  depreciation,  and  in  such  cases  it  is  customary  to 
state  profits  before  making  such  provision,  and  either  to 
apply  a  proportion  of  the  profits  in  purchasing  or  developing 
other  areas,  or  to  return  the  whole  to  the  owners  with  the 
clear  understanding  that  the  amounts  they  receive  represent 
a  return  of  capital  as  well  as  a  distribution  of  profits. 

Amortization  of  Leaseholds 

The  term  depreciation  is  frequently  applied  to  the  amor- 
tization of  properties  of  which  the  lease  only  and  not  the 
freehold  has  been  purchased.  It  is  not,  however,  a  correct 
term  to  apply  in  such  cases;  for  the  so-called  purchase 
money,  being  merely  rent  paid  in  advance  over  the  term  of 
the  lease,  is  the  present  value  of  an  annuity  for  that  term, 
the  annual  instalments  of  which  should  be  charged  against 
profits  in  due  course.  In  practice  the  straight  line  method  is 
frequently  adopted  in  these  cases  also,  and  an  equal  annual 
instalment  (in  the  case  of  a  twenty-year  lease)  of  one- 
twentieth  of  the  purchase  money  is  charged  into  operating 
expenses. 

Conclusion 

The  present  discussion  of  this  whole  subject  is  far  from 
exhaustive  and  deals  merely  with  the  general  principles 
involved.  Volumes  have  been,  and  may  still  be,  written  on 
the  detailed  application  of  the  various  methods  to  different 
undertakings,  and  to  these  volumes —  and  to  papers  on  the 
subject  appearing  in  the  many  technical  journals — reference 
should  be  made. 


174   ACCOUNTING    PRACTICE    AND    PROCEDURE 

A  word  of  caution  may  not  be  out  of  place  as  to  the 
essential  part  played  by  estimates  in  all  schemes  for  provid- 
ing for  current  wear  and  tear  and  future  renewals.  The  only 
test  is  actual  expenditures,  together  with  a  skilled  examina- 
tion of  the  physical  properties.  Few  schemes  have  been  in 
force  for  a  sufficiently  long  period  to  provide  a  test  of  their 
accuracy;  and  organic  changes  by  sale,  reconstruction  or 
destruction,  as  well  as  the  rapid  growth  of  land  values,  have 
all  tended  to  confuse  the  issue.  A  few  cases  in  special 
industries  have  tended  to  show  that  provisions  for  deprecia- 
tion have  been  inadequate  in  these  cases  to  provide  for 
necessary  changes ;  and  there  are  other  cases  in  which  exces- 
sive and  evident  liberality  has  produced  an  opposite  result. 
Conservative  policy  would,  under  these  circumstances,  aim 
at  ample  provision  in  years  of  good  profits,  while  main- 
taining the  estimated  minimum  in  hard  times ;  such  a  policy 
builds  up  ample  reserves  which  will  often  be  useful  in  tiding 
over  long  periods  of  depression,  and  generally  conserving 
and  strengthening  the  business  against  unforeseen  contin- 
gencies which  may  easily  bring  less  conservative  concerns  to 
disaster.  While  a  greater  approach  to  scientific  accuracy  in 
all  such  matters  is  much  to  be  desired,  real  safety  lies  rather 
in  an  ample  provision  than  in  a  strictly  accurate  one. 


CHAPTER  VIII 

SPECIAL  POINTS  IN  CORPORATION  ACCOUNT- 
ING AND  FINANCE 

( I )  Accounting  for  Holding  Companies 

The  now  common  practice  of  forming  large  aggre- 
gations of  capital  on  the  basis  of  a  control  by  one  corporation 
of  the  whole  or  the  majority  of  the  stocks  of  a  number  of 
others,  raises  important  accounting  questions. 

It  has  generally  been  considered  that  the  balance  sheet 
of  any  corporation,  prepared  from  its  books  and  records 
properly  kept,  would  disclose  its  true  financial  position ;  but 
the  development  of  this  system  of  control  has  shown  that 
such  a  balance  sheet  will  no  longer  suffice  for  this  purpose. 

It  is  important  in  this  connection  to  realize  the  differ- 
ence between  an  investment  in  a  company  when  this  invest- 
ment represents  only  a  small  proportion  of  its  capital  stock, 
and  an  investment  representing  the  whole  or  practically  the 
whole,  and  carrying  with  it  the  absolute  control  of  the 
operations.  Thus,  corporation  "A"  may  own  the  whole 
stock  of  corporation  "B,"  both  carrying  on  a  similar  busi- 
ness. Stockholders  in  "A"  may  know  this  fact,  but  have  no 
means  of  ascertaining  the  real  position  of  corporation  "B." 
"A,"  having  the  control  of  "B,"  may  turn  over  to  "B"  all 
its  unremunerative  work,  with  the  result  of  showing  large 
profits  on  its  own  accounts,  while  the  accounts  of  "B"  show 
correspondingly  large  losses.  Corporation  "A"  in  its  bal- 
ance sheet  may  carry  its  investments  at  cost,  probably  merged 

175 


176  ACCOUNTING    PRACTICE    AND    PROCEDURE 

under  the  general  head  of  "Cost  of  Properties,"  with  all  its 
other  capital  assets.  Corporation  "B"  may  obtain  loans 
from  corporation  "A"  which  largely  exceed  its  current 
assets,  and  may  be  expended  in  construction  work,  or  even 
lost  in  operations,  while  corporation  "A"  may  carry  in  its 
balance  sheet  these  same  loans  as  current  assets  recoverable 
on  demand. 

The  Consolidated  Balance  Sheet  and  Income  Account 

By  reason  of  the  misleading  character  of  the  ordinary 
balance  sheet  in  such  cases,  there  has  been  evolved  the 
consolidated  balance  sheet;  the  basis  of  which  is  the  recog- 
nition of  the  common-sense  fact  that  a  network  of  com- 
panies connected  with  each  other  by  control  of  stockholdings, 
is  still  in  effect  one  undertaking,  and  that  if  the  stockholders 
in  the  holding  company  are  to  have  before  them  a  clear 
statement  of  its  position,  legal  technicalities  must  be  brushed 
to  one  side,  and  the  position  of  the  holding  company  shown 
in  its  relation,  not  to  these  subcompanies,  but  to  the  general 
public.  The  position  of  the  holding  company  can  only  be 
changed  by  outside  influences  affecting  itself  or  its  con- 
stituent companies,  and  not  by  any  change  in  the  relation 
between  itself  and  these  companies,  or  in  the  relations  among 
the  latter.  The  consolidated  balance  sheet  represents  the 
true  position  of  the  whole  group  of  the  constituent  com- 
panies to  the  outside  world,  and  is  thus  not  the  balance 
sheet  of  a  corporation,  but  of  a  condition  after  eliminating 
all  the  relations  of  the  constituent  companies  one  to  another. 
Debts  due  by  one  company  of  the  group  to  another;  stocks 
of  one  company  owned  by  another ;  earnings  of  one  company 
at  the  expense  of  another — are  all  eliminated.  The  amount 
by  which  the  value  of  the  stocks  of  any  company  on  the 
books  of  another  exceeds  or  falls  short  of  the  par  value 
thereof,  represents  an  addition  to  or  diminution  of  the  asset 


CORPORATION    ACCOUNTING    AND    FINANCE  177 

of  goodwill  in  the  final  balance  sheet;  and  as  a  result  the 
capital  assets  in  the  consolidated  balance  sheet  consist  of 
the  total  physical  assets  of  all  the  companies  (that  is,  land, 
buildings,  plant,  machinery,  etc.),  and  in  addition  an  item 
of  goodwill  represented  by — 

(a)  The  goodwill  asset  in  the  balance  sheets  of  the 

separate  companies,  and 

(b)  The  amount  by  which  the  aggregate  book  value  to 

the  holding  company  of  the  stocks  of  subsidiary 
companies  exceeds  the  par  value  of  that  stock 
and  the  surplus  at  the  date  of  acquisition. 

Similarly,  the  capital  liabilities  represent  the  stocks  and 
bonds  of  all  the  companies  in  the  hands  of  the  public,  those 
owned  between  companies  being  eliminated. 

The  consolidated  earnings  account  is  made  up  on  the 
same  principles.  Profits  resulting  to  one  company  out  of 
sales  to  another  are  eliminated.  Only  sales  and  purchases 
to  and  from  the  outside  public  are  included,  so  that  no  profits 
are  considered  such  except  those  made  on  deliveries  outside 
the  organization. 

In  other  words,  the  whole  organization  is  considered  as 
merely  a  series  of  separate  works  under  the  same  ownership ; 
and  the  same  accounting  principles  which  would  apply  to  a 
corporation  owning  several  factories,  are  applied  to  the  one 
owning  the  whole  stocks  of  a  number  of  subsidiary  com- 
panies, which  in  turn  own  the  stocks  of  other  subsidiary 
companies,  all  the  companies  in  the  group  themselves  owning 
and  operating  their  own  factories.  It  will  readily  be  under- 
stood that  in  practice  the  preparation  of  a  statement  of 
earnings  exactly  on  the  basis  here  laid  down  is  a  difficult 
matter ;  but  inasmuch  as  a  neglect  of  these  principles,  so  far 
as  the  Income  account  is  concerned,  only  means  the  swelling 
of  the  totals  both  of  gross  earnings  and  cost  of  operation,  it 


178  ACCOUNTING    PRACTICE    AND    PROCEDURE 

is  not  of  so  much  importance;  provided  that  the  valuation 
of  the  stocks  of  goods  on  hand  is  made  on  the  basis  of  actual 
labor,  material,  and  expense  involved  therein,  without  in- 
cluding any  proportion  of  the  profit  of  the  different  com- 
panies in  the  organization  through  which  these  products  may- 
have  come,  and  provided  also  that  capital  expenditures  do 
not  contain  any  intercompany  profit. 

A  balance  sheet  of  a  corporation,  whose  only  or  principal 
assets  are  stated  to  be  investments  in  other  companies,  should 
be  looked  upon  with  suspicion,  unless  the  names  of  the 
other  companies  are  given,  and  clear  statements  are  also 
given  of  their  financial  position ;  and  even  then  a  collection 
of  balance  sheets  can  not  show  the  true  financial  position  of 
the  whole  group  until  they  are  all  combined  into  one  and 
the  intercompany  interests  eliminated. 

In  respect  of  the  earnings  of  such  a  consolidation  similar 
considerations  prevail.  Legally,  the  earnings  consist  of  the 
results  of  the  operations  of  the  holding  company,  together 
with  any  dividends  which  may  be  declared  on  the  stocks 
which  it  owns  in  the  subsidiary  companies;  and  so  long  as 
those  stocks  represent  only  minority  interests  in  companies 
which  are  not  in  any  way  controlled  or  operated  by  the 
directors  of  the  holding  company,  an  Income  account  pre- 
pared in  such  a  way  would  be  a  correct  and  proper  statement 
from  an  accounting  as  well  as  from  a  legal  point  of  view. 

Under  the  conditions,  however,  of  majority  or  complete 
ownership,  as  they  so  commonly  exist,  no  statement  of  earn- 
ings can  be  considered  correct  which  does  not  show  in  one 
account  the  profits  or  losses  of  the  whole  group  of  com- 
panies, irrespective  of  whether  dividends  have  or  have  not 
been  declared  thereby.  If  this  principle  be  not  insisted  upon, 
it  is  within  the  power  of  the  directors  of  the  holding  com- 
pany to  regulate  its  profits  according  not  to  facts,  but  to  their 
own  wishes,  by  distributing  or  withholding  dividends  of  the 


CORPORATION    ACCOUNTING    AND    FINANCE  179 

subsidiary  companies ;  or  even  to  largely  overstate  the  profits 
of  the  whole  group  by  declaring  dividends  in  those  sub- 
companies  which  have  made  profits,  while  entirely  omit- 
ting to  make  provision  for  losses  which  have  been  made 
by  other  companies  in  the  group. 

Legal  Status  of  Consolidated  Balance  Sheet 

It  is  doubtful  whether  there  is  any  existing  law  which 
could  legally  require  a  corporation  to  make  up  its  statement 
of  profits  on  the  basis  here  suggested ;  but  possibly  it  may 
eventually  be  found  that  the  ordinary  rule,  of  a  reasonable 
valuation  of  assets,  may  be  made  to  cover  this  point,  for  the 
following  reasons.  It  is  clear  that  whatever  the  value  of 
an  investment  in  a  corporation  may  be  at  a  particular  date, 
its  value  at  any  subsequent  date  (other  things  being  equal) 
must  be  greater  or  less  by  the  amount  of  the  profits  or  losses 
made  and  not  distributed  during  the  intervening  period. 
Even  if  other  conditions  at  the  two  dates  are  not  the  same, 
and — quite  apart  from  any  consideration  of  the  earnings  or 
losses  during  the  intervening  period — there  is  a  considerable 
appreciation  or  depreciation  in  the  investment,  that  apprecia- 
tion or  depreciation  must  undoubtedly  be  more  or  less, 
respectively,  by  reason  of  profits  earned  or  losses  incurred. 
The  change  in  value  of  the  asset  is  at  any  rate  partly  due  to 
the  result  of  the  operations  for  the  purpose  of  which  the 
investment  is  held.  On  the  general  principle,  therefore,  that 
an  Income  account  should  take  into  account  all  profits  or 
losses  resulting  from  the  trading  operations,  but  should  not 
take  into  account  the  profits  or  losses  arising  from  a  revalu- 
ation of  capital  assets,  it  may  eventually  be  held,  on  legal  as 
well  as  on  accounting  principles,  that  the  statement  of  earn- 
ings presented  by  a  holding  company  is  not  correct  unless  it 
takes  into  account,  by  way  of  either  a  reserve  or  a  direct 
addition  to  or  deduction  from  the  capital  value  of  the  invest- 


l8o    ACCOUNTING    PRACTICE    AND    PROCEDURE 

ment,  the  profits  or  losses  made  in  operating  the  subsidiary 
companies. 

Intercompany  Profits  and  Accounting 

In  a  large  consolidation,  when  the  subsidiaries  are  carry- 
ing on  business  as  separate  entities,  and  contracting  and 
dealing  with  each  other  as  independent  concerns,  the  elimina- 
tion of  profits  on  sales  or  transfers  between  companies  is  a 
somewhat  difficult  and  complicated  matter,  particularly 
having  regard  to  the  fact  that  each  subsidiary  company  is 
legally  entitled  to  take  up  the  profits  on  such  sales,  and,  if 
there  are  substantial  minority  interests  outstanding,  has  no 
right  to  exclude  them.  This  difficulty  has  been  overcome  by 
means  of  an  elaborate  system  of  accounting  which  provides 
for  carrying  the  intercompany  profit  through  the  operations 
as  a  separate  item  from  the  original  cost,  until  such  time  as 
the  finished  product  is  sold  to  parties  outside  the  consolida- 
tion. The  method  by  which  this  result  is  accomplished  may 
be  shortly  outlined  as  follows : 

Company  A  produces  a  raw  material  and  sells  it  to  com- 
pany B  at  a  profit  of,  say,  lo  per  cent;  company  B  converts 
this  raw  material  into  a  partly  finished  product  and  ships  it 
over  a  railroad  C,  owned  by  the  consolidation,  to  company 
D,  by  whom  it  is  further  manufactured  and  finally  sold  to 
outside  parties.  Company  A  produces  material  to  the  cost 
value  of  $100,000,  and  sells  $20,000  of  this  to  outside 
parties,  $60,000  to  company  B,  and  has  the  remaining 
$20,000  in  stock.  Company  B  buys  material  from  company 
A,  costing  $60,000,  for  $66,000 ;  spends  $34,000  in  further 
manufacture;  ships  $70,000  of  the  manufactured  product 
over  railroad  C  to  company  D ;  sells  $20,000  to  outsiders, 
and  has  $10,000  in  stock.  Company  D  purchases  products 
from  company  B,  costing  $70,000,  for  $77,000;  pays  $5,.ooo 
freight    to    railroad    C — which    costs    the    latter    $3,500; 


CORPORATION    ACCOUNTING    AND    FINANCE   l8l 

expends  $i8,0(X)  in  completing  its  manufacture;  sells 
$8o,cxx)  of  the  finished  product  to  outsiders,  and  has  the 
remaining  $20,000  in  stock. 

The  books  of  company  A  require  no  special  entries. 
In  company  B's  books  its  Manufacturing  account  will 
stand  as  follows : 

I.  C.  Profit     1st  Cost  Total 

Cost  of  material ....   $6,000     $60,000       $66,000 
Manufacturing  cost 34>ooo         34,000 


$6,000     $94,000     $100,000 


Cost  of  Sales : 

To  outside  parties     1,200       18,800         20,000 
To  Company  D..     4,200       65,800         70,000 


Balance  in  stock.  ....      $600       $9,400  $10,000 

In  company  D's  books  the  Manufacturing  account  will 
be  dealt  with  similarly,  as  follows  : 

I.  C.  Profit     1st  Cost  Total 
Cost  of  material  per 

Company   B....   $11,200     $65,800  $77,000 

Freight... 1,500         3,500  5,000 

Manufacturing  cost       18,000  18,000 


$12,700     $87,300     $100,000 
Cost  of  Sales : 

To  outside  parties    10,160       69,840         80,000 


Balance  in  stock .. .     $2,540     $17,460       $20,000 

The  subsidiary  companies  will  take  up  in  their  Income 
accounts  the  whole  of  their  profits  on  their  sales,  and  will 
declare  dividends  in  the  usual  way.  Out  of  the  dividends  it 
receives,  the  holding  company  will  set  up  $600  in  respect  of 
B's  profits,  and  $2,540  in  respect  of  D's  profits,  or  a  total  of 


l82    ACCOUNTING    PRACTICE    AND    PROCEDURE 

$3,140,  which  will  be  credited  to  an  inventory  reserve.  In 
this  way,  all  stocks  on  hand  of  all  companies  are,  on  the 
consolidated  balance  sheet,  carried  at  net  cost  within  the 
consolidation,  and  the  consolidated  income  takes  up  no  profit 
except  on  sales  made  to  outside  parties.  If  any  of  the 
product  is  used  for  construction  work  within  the  organiza- 
tion, the  net  cost  only  is  used,  so  that  no  profit  of  subsidiary 
companies  enters  into  capital  expenditures. 

The  actual  process,  by  reason  of  the  magnitude  of  the 
business  and  number  of  transactions,  is  necessarily  more 
complicated  than  the  simple  example  given,  which,  however, 
is  sufficient  to  show  the  principles  involved. 

What  is  a  Constituent  Company? 

One  other  difficult  point  is  the  determination  of  what  is 
or  is  not  a  constituent  company  whose  Profits  and  Losses 
or  Assets  and  Liabilities  should  be  brought  into  account  in 
this  manner.  It  is  suggested  that  this  depends  partly  on  the 
proportion  of  stock  owned,  and  partly  upon  the  degree  of 
control  exercised  by  the  holding  company.  When  the  latter 
owns  at  least  a  majority  of  the  stock,  operates  the  company, 
dictates  its  policy,  and  practically  treats  its  property  as  its 
own,  subject  only  to  the  right  of  the  minority  stockholders 
to  receive  a  share  of  the  profits,  the  conditions  would  appear 
to  be  such  as  to  require  the  proportion  of  profits  and  losses 
corresponding  to  the  stock  owned  to  be  taken  up.  In  order 
to  justify  a  consolidated  balance  sheet,  in  addition  to  the 
other  conditioiis  just  mentioned,  the  ownership  of  at  least 
the  common  stock  should  be  substantially  complete;  or  the 
balance  not  owned  should  consist  either  of  shares  left  in 
the  hands  of  managers  or  others  for  business  purposes,  or 
of  shares  the  ownership  of  which  cannot  be  traced.  On 
the  other  hand,  a  mere  majority  ownership  of  stock  without 
any  effective  control  of  the  management  and  operation. 


CORPORATION    ACCOUNTING    AND    FINANCE  183 

should  properly  be  treated  as  a  permanent  investment,  sub- 
ject to  the  same  rules  as  other  investments  of  a  similar 
character. 

The  conditions  under  which  any  stock  of  a  subsidiary 
company  remains  outstanding  are  of  some  importance,  not 
only  in  determining  whether  the  ownership  of  the  holding 
company  is  sufficient  to  justify  or  require  consolidated 
accounts,  but  also  in  determining  what  proportion,  if  any,  of 
the  surplus  should  appear  on  such  a  balance  sheet  as  apper- 
taining to  the  minority  stockholders.  The  proper  practice 
is  to  take  up  as  a  liability  the  par  value  of  the  outstanding 
stock,  together  with  its  relative  share  of  surplus ;  but  when 
the  amount  involved  is  small,  the  proportion  of  surplus  is 
not  always  set  aside. 

If  minority  stock  is  left  outstanding  by  deliberate  intent, 
as,  for  instance,  to  give  managers  of  the  company  a  sub- 
stantial interest  in  its  results,  then  a  share  of  any  undis- 
tributed surplus  clearly  appertains  to  this  outstanding  stock, 
and  the  liability  to  be  taken  up,  therefore,  is  the  par  value  of 
the  stock,  together  with  the  proper  proportion  of  the 
accumulated  surplus. 

Other  Forms  of  Consolidated  Statements 

While  the  consolidated  balance  sheet  already  discussed 
is  on  the  whole  the  best  method  of  stating  the  accounts  of  a 
holding  company  with  a  group  of  controlled  subsidiaries,  it 
is  not  necessarily  the  only  one.  It  must  be  remembered 
always  that  the  object  of  accounts  is  to  show  facts,  and  that 
any  form  of  statement  which  discloses  all  material  facts  is 
equally  permissible  and  proper;  whether  one  or  other  of 
these  forms  should  be  adopted,  is  largely,  but  within  limits, 
a  matter  of  individual  preference. 

Such  statements  are  frequently  prepared  in  a  form  in 
which  there  is  shown,  as  one  item  in  the  balance  sheet  of  the 


l84    ACCOUNTING    PRACTICE    AND    PROCEDURE 

holding  company  under  the  heading  of  "Investments  in  Sub- 
sidiary Companies  Controlled,"  the  total  cost  to  the  holding 
company  of  the  stocks  of  its  subsidiary  companies.  This  is 
supported  by  a  columnar  statement,  each  separate  column 
of  which  contains  the  assets  and  liabilities  of  one  subsidiary 
company  under  the  usual  and  proper  headings;  while  the 
total  column  contains  a  summary  of  all  the  detail  columns, 
eliminating  intercompany  items,  and  adding  or  deducting 
the  amounts  by  which  the  prices  paid  by  the  holding  company 
for  the  stocks  of  the  subsidiaries  exceed  or  fall  short  of 
the  par  value  of  their  stocks  and  surplus. 

The  consolidated  balance  sheet  shows  to  shareholders 
of  the  holding  company  the  position  of  the  interests  they 
own  or  control  through  these  shares,  but  it  does  not  per- 
haps answer  this  purpose  so  well  for  either  creditors  of,  or 
minority  stockholders  in,  subsidiary  companies.  The  con- 
solidated balance  sheet,  being  a  grouped  balance  sheet,  does 
not  distinguish  between  the  liabilities  of  different  companies 
in  the  group,  and  does  not  show  separately  the  assets  to 
which  the  creditors  must  look  for  the  discharge  of  these 
liabilities.  Similarly,  the  stocks  outstanding  in  the  hands 
of  the  public  are  shown  as  representing  all  the  assets  in  the 
consolidation,  and  no  separation  is  made  of  those  appertain- 
ing to  the  stocks  of  any  particular  subsidiary  company  out- 
standing in  the  hands  of  the  public. 

Such  objections  apply  in  a  lesser  degree  to  the  balance 
sheet  of  any  single  company  which  has  different  classes  of 
bonded  debt,  each  secured  on  separate  assets.  The  objec- 
tions in  the  case  of  the  consolidated  balance  sheet,  as  in  the 
case  of  any  ordinary  balance  sheet,  can  be  met  by  subsidiary 
schedules  giving  the  information  required,  or  by  publishing 
the  balance  sheet  of  each  separate  company  as  well  as  the 
consolidated  one. 


CORPORATION    ACCOUNTING    AND    FINANCE  185 

(2)  Profits  Earned  Before  Date  of  Consolidation 

A  question  of  considerable  importance  in  its  bearing  upon 
the  determination  of  profits  in  a  holding  company,  or  in  any 
corporation  which  has  acquired  a  going  business,  is  that  of 
the  proper  disposition  of  the  profits  of  the  consolidating 
companies,  or  of  the  purchased  business,  earned  prior  to  the 
date  of  consolidation.  There  is  a  clear  rule  of  common 
sense,  and  probably  also  of  law,  that  a  corporation  cannot 
earn  profits  before  it  exists;  when,  therefore,  a  corporation 
at  its  organization  purchases  an  undertaking,  together  with 
the  profits  accrued  from  a  certain  prior  date,  the  whole  of 
such  profits  earned  prior  to  the  date  of  purchase  must  be 
treated  as  a  deduction  from  the  purchase  price,  and  not  as  a 
credit  to  Income  account  available  for  dividends. 

This  proposition  is  the  more  evident  if  it  be  remembered 
that  these  profits  exist  in  the  form  of  assets  included  among 
those  purchased,  and  that  any  realization  thereof  is  merely  a 
return  to  the  purchasing  company  of  a  portion  of  the  pur- 
chase money,  i.  c,  of  the  capital  of  the  corporation.  Similar 
reasoning  will  show  that  where  a  holding  corporation  pur- 
chases the  stocks  of  several  others,  all  profits  of  the  pur- 
chased corporations  accruing  up  to  the  date  of  the  purchase 
must  be  treated  by  the  holding  corporation  as  a  deduction 
from  the  price  paid.  The  subsidiary  corporations  can  legally 
declare  dividends  therefrom;  but  these  dividends,  when 
received  by  the  holding  corporation,  are  merely  a  transfer  to 
it  of  some  of  the  assets  included  in  the  value  of  the  stock  it 
purchased,  and  are  therefore  a  return  of  capital ;  and  divi- 
dends declared  and  paid  by  the  holding  corporation  to  its 
stockholders  out  of  such  profits  would  clearly  be  paid  out  of" 
capital.  It  is  important  to  note  that  the  date  of  purchase 
should  be  taken  as  the  date  of  the  contract  for  purchase,  and 
not  the  date  of  completion.  If  the  purchasing  corporation 
was  in  existence  at  the  date  of  entering  into  the  contract,  it 


l86    ACCOUNTING    PRACTICE    AND    PROCEDURE 

is  to  be  presumed  that  the  price  fixed  had  relation  to  the 
conditions  existing  at  that  date,  and  that  the  corporation  is 
entitled  to  treat  as  profits  all  earnings  of  the  subsidiary  cor- 
porations subsequent  to  that  date,  less  any  consideration, 
such  as  interest,  given  for  those  profits.  But  if  the  holding 
corporation  had  no  legal  existence  until  a  later  date,  it  is  sub- 
mitted that,  as  it  cannot  earn  profits  when  it  is  not  in  exist- 
ence, it  is  only  entitled  to  distribute  as  dividends  profits  of 
the  subsidiary  corporations  earned  subsequent  to  its  own 
incorporation,  or  to  the  purchase  of  the  property,  whichever 
is  the  later  date. 

(3)  Questions   Arising  on   the   Organization   of  a 
Corporation 

Initial  Surplus 

It  frequently  happens  that  a  corporation  contracts  to 
purchase  property  at  an  agreed  price,  which  on  the  face  of 
the  contract  is  declared  to  be  its  value,  and  that  by  another 
clause  in  the  contract,  or  by  another  contract,  the  vendors 
agree  to  provide,  in  addition  to  the  property,  a  certain  sum 
in  cash  for  working  capital  or  even  for  free  surplus.  It  is 
sometimes  maintained  that  this  free  sum  so  provided  is  a 
profit  or  surplus  of  the  new  corporation  available  for  pay- 
ment of  dividends  if  the  directors  so  determine.  It  is  sub- 
mitted that  this  contention  is  entirely  unsound.  Vendors  are 
men  of  business,  and  it  is  not  their  practice  to  give  something 
for  nothing.  A  contract  must  be  assumed  to  be  the  result  of 
a  bargain  between  purchaser  and  seller,  and  whatever  the 
purchaser  is  to  receive  under  the  contract  must  -be  set  ofi 
exactly  against  what  the  vendor  is  to  receive ;  and  although, 
in  the  formation  of  a  large  number  of  modern  corporations, 
the  vendors  and  purchasers,  through  the  intervention  of 
syndicates,  are  one  and  the  same,  the  only  safe  and  sound 


CORPORATION    ACCOUNTING    AND    FINANCE  187 

method  of  accounting  is  to  assume  that  the  same  principles 
apply  as  in  the  case  of  an  ordinary  sale.  It  is  difficult  to 
believe  that,  if  such  a  contract  formed  the  subject  of  legal 
proceedings,  any  other  view  could  be  taken  than  that  the 
so-called  gift  for  working  capital  was  merely  a  return  to  the 
purchaser  of  a  portion  of  his  purchase  money,  and  should 
be  so  treated  in  the  accounts.  If  the  reverse  principle  were 
upheld,  and  this  gift  were  treated  as  a  clear  profit  to  the 
corporation  and  distributed  in  dividends,  it  would  seem  that 
a  portion  of  the  subscribed  capital  would  in  effect  be  returned 
to  the  stockholders. 

In  a  few  exceptional  cases  properties  are  transferred  to 
corporations  at  appraised  values,  and  for  some  reason  the 
stock  and  other  securities  issued  for  the  properties  have  an 
aggregate  par  value  less  than  the  appraised  value  of  the 
properties  and  all  other  net  assets.  Assuming  that  the 
appraisals  are  genuine,  it  would  seem  that  in  such  a  case  the 
corporation  commences  business  with  a  real  surplus,  which, 
however,  is  clearly  a  capital  and  not  an  income  one.  Such 
a  condition  can  only  exist  when  the  appraisals  cover  sub- 
stantially all  the  assets. 

Losses  on  Current  Assets  Acquired 

Other  accounting  questions  relating  to  the  formation  of 
consolidating  corporations  have  relation  to  losses  that  may 
occur  on  current  assets  taken  over  from  the  vendors.  The 
valuation  of  inventories  for  purposes  of  transfer  from  a 
vendor  to  a  purchaser  is  frequently  made  on  a  higher  basis 
than  would  be  usual  for  a  going  concern,  the  vendor  in  effect 
stipulating  for  some  profit  on  his  unsold  product.  The 
excess  over  the  fair,  going  value  of  the  inventory  must  in 
such  cases  be  considered  as  an  addition  to  the  fixed  capital 
investment  in  the  shape  of  goodwill. 

Similarly,  if  debts  and  liabilities,  as  is  sometimes  the  case, 


l88    ACCOUNTING    PRACTICE    AND    PROCEDURE 

are  taken  over  without  any  guarantee  from  the  vendor,  and 
a  loss  occurs  on  final  realization  and  payment,  this  loss  may 
also  be  treated  as  an  addition  to  the  amount  paid  for  good- 
will. These  principles  are  in  accord  with  those  heretofore 
laid  down,  that  profits  and  losses  of  a  corporation  are  such 
as  arise  out  of  its  operations  subsequent  to  the  date  of  its 
formation  or  of  the  purchase  of  its  properties,  and  that 
profits  and  losses  appertaining  to  a  period  prior  to  these 
dates  are  capital  items. 

Adjustment  of  Inventories  on  Purchase  and  Sale  of  a  Busi- 
ness 

It  frequently  happens  that  the  vendors  have  many  con- 
tracts in  force  for  the  purchase  of  materials  or  supplies  or 
manufactured  articles,  at  prices  differing  widely  from  the 
market  price  at  the  date  of  sale.  It  is,  therefore,  fair  both  to 
the  vendor  and  the  purchaser  in  such  cases  that  some  regard 
should  be  paid  to  such  contracts.  If  the  vendor  has  made 
advantageous  contracts  a  long  way  ahead  at  a  time  of  low 
prices,  the  purchaser  is  certainly  getting  something  more 
than  the  mere  business  contracted  for;  on  the  other  hand,  if 
such  contracts  for  purchase  are  above  current  market  prices, 
then  the  purchasing  company  is  in  a  worse  position  than  it 
otherwise  would  be.  It  is,  however,  doubtful  whether  it 
is  a  fair  proposition  as  between  the  vendor  and  the  pur- 
chaser that  the  market  price  on  the  date  of  the  transfer 
should  necessarily  form  the  basis  of  a  settlement  between 
them.  Some  allowance  must  be  made  for  the  good  judgment 
of  the  purchasers,  and  they  should  not  be  required  to  take 
over  large  quantities  of  materials  on  the  fixed  date  of 
acquiring  the  property,  at  prices  which  in  the  ordinary  course 
of  business  they  might  not  have  considered,  when  the  trans- 
fer of  such  an  inventory  at  the  top  market  price  may  have 
a  considerable  effect  on  the  future  prosperity  of  the  business. 


CORPORATION    ACCOUNTING    AND    FINANCE   189 

It  is  certainly,  therefore,  a  material  fact  to  the  intending 
investor  that  he  should  be  clearly  informed  on  what  basis 
of  price  the  inventories  will  be  acquired,  and  what  contracts 
for  purchase  of  materials  or  manufactured  articles  have 
been  entered  into  at  prices  differing  from  those  current. 
Another  material  factor  is  the  amount  of  orders  on  hand  for 
future  delivery,  and  the  prices  therefor,  and  the  proportion 
such  orders  might  bear  to  the  possible  capacity  of  the  works. 
As  a  rule  a  large  number  of  orders  on  hand  may  be  regarded 
as  a  source  of  strength  if  they  have  been  obtained  in  the 
ordinary  course  of  business  and  at  reasonably  remunerative 
prices.  It  is,  on  the  other  hand,  an  easy  matter  to  obtain 
orders  if  no  regard  be  paid  to  the  prices,  and  it  might  happen 
that  an  unscrupulous  promoter  had  built  up  a  large  prospec- 
tive business,  at  totally  unremunerative  prices,  for  the  sole 
purpose  of  transfer  to  the  purchasing  company.  Even  with- 
out any  fraudulent  intent  it  may  be  that,  owing  to  a  consider- 
able rise  in  costs,  either  of  raw  materials  or  labor,  or  both, 
the  vendor  concern  may  have  on  hand  contracts  taken  when 
the  range  of  prices  was  much  lower,  which  can  be  filled  only 
at  considerable  loss  to  the  purchasing  company.  Similarly, 
orders  on  hand — to  be  completed  by  a  fixed  time — to  an 
amount  largely  in  excess  of  the  actual  or  contemplated 
factory  capacity,  might  easily  be  a  source  of  loss  rather  than 
of  profit  to  the  purchaser. 


These  are  some  and  perhaps  the  more  important  of  the 
questions  that  may  arise  in  practice  when  a  new  corporation 
is  formed  to  take  over  one  or  more  businesses  as  going 
concerns. 


CHAPTER   IX 

SOME  THEORIES  AND  PROBLEMS  IN 
COST  ACCOUNTING 

The  subject  of  cost  accounts  is  one  of  the  widest  import- 
ance, and  on  its  practical  side  calls  for  a  fuller  treatment 
than  is  possible  in  a  general  work  on  accounting.  The 
economic  theories  involved  in  determining  the  cost  of  any- 
given  article  of  manufacture,  together  with  an  outline  of  the 
general  methods  of  cost  accounting,  and  some  of  the  more 
important  problems  involved  therein,  form  the  subject  of 
this  chapter. 

The  term  "manufacture"  used  in  its  widest  sense  com- 
prises every  operation  necessary  to  render  a  natural  product 
available  for  use,  and  by  so  doing  to  give  it  a  value  based 
upon  cost  in  excess  of  that  which  it  had  in  its  natural  state. 

The  elements  that  enter  into  the  process  of  manufacture 
are: 

(i)   The  natural  product  itself — or  material. 

(2)  The  subsistence  necessary  for  the  labor  or  service 
employed  in  converting  it  to  use  in  the  place 
where  it  is  required,  and  during  the  time  occupied 
in  this  process — or  labor. 

In  these  elements  nothing  in  the  nature  of  profit  is 
involved,  for  the  reason  that  profit  is  represented  by  the 
difference  between  the  actual  cost  of  labor  and  material, 
and  the  value  which  the  combination  of  labor  with  material 

190 


PROBLEMS    IN     COST    ACCOUNTING  191 

has  given  to  the  finished  product,  this  being  dependent  on 
the  demand  for  and  supply  of  the  particular  article.  The 
resultant  value  so  determined  may  at  any  moment  be  more 
or  less  than  the  cost  of  the  primary  elements,  and  if  it 
exceeds  this  cost  there  is  a  profit,  which  is  divisible  among — 

(i)  The  individuals  whose  joint  efforts  have  brought 
this  natural  product  into  the  shape  for  which 
and  to  the  place  at  which  the  demand  exists,  i.  e., 
labor. 

(2)  The  owner  of  the  natural  product  and  the  owner  of 
the  accumulations  which  provide  for  the  subsist- 
ence of  labor  during  the  period  of  manufacture, 
i.  e.,  the  capitalist. 

If,  on  the  other  hand,  the  selling  value  falls  short  of  the 
cost,  the  loss  must  fall  upon  the  capitalist;  labor  merely 
going  without  profit,  except  to  the  extent  that  the  condition 
of  the  labor  market  may  enable  it  to  obtain  in  advance  a 
definite  sum,  in  lieu  of  its  share  of  the  prospective  profit 
which  may  or  may  not  be  eventually  realized. 

Nature  of  Plant 

At  first  sight  it  may  appear  that  this  elementary  descrip- 
tion loses  sight  of  the  important  part  which  land,  buildings, 
plant  and  machinery  play  in  the  process  of  manufacture. 
A  little  consideration  will  show  that  this  is  not  so ;  but  that 
these  too  fall  naturally  into  the  elements  already  given,  each 
item  involving  the  use  of  a  natural  product,  and  its  conver- 
sion by  means  of  labor  over  a  period  of  time  necessitating 
the  provision  of  subsistence  by  a  capitalist.  For  instance, 
the  conversion  of  ore  into  manufactured  steel  involves  the 
following  operations : 

(i)  Natural  products  consumed,  i.  e.,  ore,  coal,  timber, 
etc. : 


192    ACCOUNTING    PRACTICE    AND    PROCEDURE 

(2)  Natural  product  used  but  not  consumed,    i.  e.,  land 

upon  which  to  carry  on  operations; 

(3)  Labor — 

(a)  Extracting  ore  in  some  very  primitive  way; 

(b)  Smelting  this  ore  in  some  equally  primitive 

way,  and  with  the  use  of  fuel  of  some 
sort,  both  these  processes  being  carried  out 
as  by  savages  with  no  provided  facilities ; 

(c)  The  manufacture  of  some  kind  of  tools  by 

using  the  natural  products  so  far  devel- 
oped, and  so,  gradually  and  over  long 
periods  of  time,  constructing  plants  suit- 
able for  manufacture; 

(d)  The    actual    manufacture    of    the    articles 

which  are  of  use  to  the  community  and 
have  an  exchangeable  value  out  of  which 
profit  can  be  realized. 

A  miore  detailed  consideration  of  the  elements  of  mate- 
rial and  labor  will  serve  to  bring  out  the  principles  involved 
in  their  determination. 

Constituent  Elements  of  Cost 

Material  cost  consists  in  the  first  instance  of  the  labor 
employed  in  obtaining  possession  of  the  material  in  its 
natural  state,  but  the  value  is  fixed  from  day  to  day  on  the 
basis  of  estimates  of  the  probable  supply  and  demand,  and 
of  the  difficulties  and  cost  of  making  it  available.  The  pur- 
chase price  so  fixed  is  in  practice  accepted  as  the  cost, 
although  it  necessarily  involves  profit  to  the  original  pos- 
sessor and  to  subsequent  owners  through  him,  who  kre  able, 
by  virtue  of  the  limitation  in  quantity  available  at  any  time, 
to  demand  a  sum  down  rather  than  wait  for  the  uncer- 
tainties of  future  profit.     The  purchase  price  thus  forms 


PROBLEMS    IN    COST    ACCOUNTING  193 

part  of  the  cost,  and  should  be  recouped  on  sale  before  any 
profit  can  be  ascertained. 

Labor  is  a  direct  element  of  cost,  represented  by  the 
provision  of  at  least  subsistence  to  those  who  perform  it, 
and  its  recompense  varies,  by  reason  of  the  supply  of  or  the 
demand  for  labor  of  different  classes,  from  the  bare  cost  of 
living  to  a  comfortable  sum  in  excess  of  that  cost.  In  effect, 
then,  whatever  share  of  ultimate  profits  the  workers  might 
eventually  receive,  is  in  most  cases  compounded  for  by  a 
payment  in  advance,  leaving  the  entire  surplus  profits  to 
accrue  for  the  benefit  of  capital,  which,  on  the  other  hand, 
also  has  to  suffer  the  loss,  if  any. 

The  capitalist  provides  from  his  accumulated  savings 
either  natural  products  for  temporary  use,  such  as  land,  or 
natural  products  for  consumption,  such  as  material  or  sub- 
sistence. The  latter,  being  consumed,  are  an  element  of  cost ; 
the  former,  remaining  unchanged,  are  not ;  the  consideration 
given  to  the  capitalist  for  permitting  his  accumulated  savings 
to  be  temporarily  used  or  consumed  is  a  share  of  the  ultimate 
profit,  or  interest,  which  in  theory  is  not  therefore  an 
element  of  cost.  In  practice  the  demand  for  capital,  like 
the  demand  for  labor,  is  such  that  the  capitalist  is  frequently 
able  to  stipulate  for  a  fixed  immediate  return  for  the  use  of 
his  accumulations ;  thereby,  as  in  the  case  of  labor,  com- 
pounding for  his  share  of  the  ultimate  profit  and  leaving 
the  balance,  with  the  whole  risk  of  loss,  to  the  borrower. 

Conditions  Affecting  Cost 

The  amounts  so  paid  by  way  of  composition  for  the 
shares  of  profit  to  labor  and  capital  may  thus  become  a  part 
of  the  cost  to  those  who  continue  to  take  the  risk;  and  it 
follows  that  the  commercial  cost  of  two  identical  articles,  the 
absolute  or  theoretical  cost  of  which  would  be  identical,  may 
be  widely  different  because  of  the  different  conditions  under 
which  the  processes  of  manufacture  have  taken  place.     As 


194    ACCOUNTING    PRACTICE    AND    PROCEDURE 

an  instance,  in  the  manufacture  of  a  complicated  machine 
the  following  alternative  conditions  may  exist : 

(i)  The  manufacturer  may  own  iron,  coal,  and  other 
mines,  and  may  at  his  own  factories  produce  everything  up 
to  the  finished  product.  In  this  case  his  costs  will  include  no 
profit  except  that  accruing  to  labor. 

(2)  He  may  purchase  all  his  natural  products  but 
carry  on  all  manufacturing  himself  at  his  own  factories.  In 
this  case  his  costs  will  include  the  profits  of  the  owner  of 
the  natural  products  as  well  as  those  of  labor. 

(3)  He  may  purchase  from  other  manufacturers  the 
whole  or  a  portion  of  the  parts  that  enter  into  his  finished 
machines.  In  this  case  his  costs  will  include  not  only  the 
profits  accruing  to  labor  and  to  the  natural  products,  but  also 
the  profits  of  any  number  of  other  manufacturers  who  have 
preferred  to  limit  their  risk  at  a  certain  point  of  the  manu- 
facturing process,  leaving  to  the  final  manufacturer  of  the 
complete  finished  product  the  whole  of  the  ultimate  profit 
or  loss. 

It  is  easily  seen  that  in  the  first  case  the  manufacturer's 
costs  are  very  much  lower  and  his  profits  very  much  higher 
than  in  the  other  two.  On  the  other  hand,  he  has  a  greater 
capital  investment,  and  is  taking  risks  by  reason  of  the 
longer  time  involved  in  the  manufacture  and  the  consequent 
greater  chance  of  eventual  fluctuations  in  demand  and 
supply.  A  practical  illustration  of  these  conditions  may  be 
found  in  a  comparison  between  the  United  States  Steel  Cor- 
poration, which  owns  its  ore  and  other  mines,  and  converts 
these  materials  into  finished  structures,  and  a  contracting 
company  which  buys  all  its  finished  material  and  itself  only 
erects  the  building  or  plant. 

Purposes  of  Cost  Accounting 

Turning  now   from  the   economic  to   the   commercial 


PROBLEMS    IN    COST    ACCOUNTING  195 

aspect  of  cost  accounts,  the  principal  objects  to  be  attained 
by  a  modern  cost  system  may  be  stated  as  follows : 

(i)  To  ascertain  the  cost  of  the  same  product  at  dider- 
ent  periods  in  the  same  mill  or  at  the  same  period  in 
different  mills,  and  so  to  remedy  inequalities  in  cost  by 
reducing  all  to  the  results  shown  by  the  best. 

(2)  By  an  accurate  ascertainment  of  the  cost  of  output, 
to  maintain  running  book  inventories,  which  will  show  at 
any  time,  without  a  physical  inspection,  how  much  of  each 
class  of  materials,  supplies,  etc.,  is  on  hand,  rendering  possi- 
ble a  reduction  of  stocks  and  capital  invested  to  the  lowest 
level  consistent  with  efficiency ;  and  at  the  same  time  avoid- 
ing the  delay,  expense  and  interruption  to  business  conse- 
quent upon  the  old  method  of  taking  a  complete  physical 
inventory  at  a  specific  date  in  each  year. 

(3)  The  preparation  of  statistical  information  as  to 
costs  of  parts,  quantity,  and  variety  of  output;  relative 
efficiency  of  different  classes  of  labor;  and  relative  costs  of 
labor  and  material,  between  different  mills  and  periods. 

(4)  The  preparation  of  periodical  statements  of  income 
in  a  condensed  form,  readily  giving  directors  all  material 
information  as  to  the  results  of  the  business.  This  is,  per- 
haps, the  least  important  of  all  the  objects  aimed  at ;  and  it 
may  safely  be  said  that  the  cost  of  a  system  designed 
merely  to  produce  periodical  statements  of  income,  without 
providing  for  the  other  and  far  more  important  objects  set 
out  above,  may  be  considered  as  money  thrown  away. 

Constituent  Elements  of  Commercial  Costs 

The  elements  involved  in  commercial  cost  accounts  are 
usually  somewhat  as  follows : 

Material — 

(i)  That  to   which   manufacturing  processes   are 
applied  to  convert  it  into  some  different  form ; 


196   ACCOUNTING    PRACTICE    AND    PROCEDURE 

(2)   That  which  is  used  or  consumed  in  the  proc- 
esses of  manufacture, 

(a)  Directly; 

(b)  Indirectly. 
Labor — 

(i)   That    employed    directly   upon    the    materials 

under  process  of  conversion ; 
(2)   That  employed  indirectly  in  operations  neces- 
sary for  the  manufacture  but  not  a  part  of  it, 
such  as  upon  repairs  to  and  upkeep  of  ma- 
chinery, buildings,  or  equipment. 
Expenses — 

Consisting  partly  of  material  and  partly  of 
labor,  which  are  incidental  to  the  carrying 
on  of  a  manufacturing  business,  but  have 
not  any  direct  relation  to  the  process  of 
manufacturing. 
Wear  and  Tear — 

Or  the  gradual  consumption  of  the  buildings, 
machinery,  and  equipment  employed  in  the 
manufacturing  process  —  more  commonly 
known  as  depreciation. 

Distribution  of  Overhead  Expense 

The  object  of  any  system  of  cost  accounts  being  to 
ascertain  the  cost  of  manufacture  of  each  article  or  class  of 
articles,  it  is  clear  that  in  a  factory  producing  many  classes 
of  product  some  method  must  be  adopted  for  distributing 
many  of  the  items  of  cost  over  these  different  classes. 

Material  in  process  of  direct  conversion  and  labor 
directly  employed  in  such  conversion  present  no  difficulties, 
being  easily  chargeable  to  the  process ;  and  the  same  is  true 
of  auxiliary  material  consumed  in  the  process  or  of  auxiliary 
labor  which  can  be  segregated  at  the  moment. 


PROBLEMS    IN    COST    ACCOUNTING  197 

There  is,  however,  a  large  class  of  items  which  cannot 
be  distributed  exactly,  and  yet  are  a  necessary  and  integral 
part  of  the  cost.  These  comprise  part  of  the  items  of  mate- 
rial and  labor,  and  the  whole  of  the  items  of  expense  and 
wear  and  tear,  and  are  usually  grouped  under  the  term 
"overhead  expense"  or  "burden,"  and  distributed  on  a 
more  or  less  arbitrary  basis  among  the  different  products. 
This  distribution  involves  difficult  questions ;  and  the  adop- 
tion of  an  erroneous  method  may  easily  appear  to  show  that 
certain  articles  are  manufactured  at  a  cost  well  below  their 
selling  price,  while  a  more  accurate  distribution  would 
show  a  reverse  condition.  The  most  usual  method  of  distri- 
bution is  by  a  straight  percentage  on  the  direct  labor  cost, 
and  where  all  products  are  of  the  same  nature  this  may 
give  fairly  accurate  results ;  but  it  is  not  scientific.  On  the 
other  hand,  a  more  scientific  system  of  distribution  based 
on  an  exhaustive  examination  of  processes,  with  a  view  to 
determining  what  share  each  operation  should  bear  of  each 
class  of  overhead  expense,  and  requiring  an  elaborate 
analysis  thereof,  may  involve  so  much  expense  as  to  be  pro- 
hibitive; and  the  final  result  may  be  found  not  to  differ 
materially  from  the  more  simple  and  ready  method  of  a 
percentage  division. 

Modern  factories  are  usually  operated  by  departments, 
between  which  there  are  well  marked  divisions.  Each  de- 
partment within  its  own  limits  occupies  a  certain  floor  space, 
involving  light  and  heat  proportionate  thereto;  uses  an 
amount  of  power  which  can  be  estimated  within  reasonable 
limits;  and  has  certain  labor  and  other  costs  for  general 
assistance,  cleaning,  stores,  and  superintendence,  which 
belong  entirely  to  its  operations  in  total.  All  these  can  be 
charged  to  the  department  and  serve  to  determine  the  burden 
of  that  department.  Some  items,  such  as  insurance,  heat 
and  light,  may  be  charged  to  the  department  on  the  basis  of 


198    ACCOUNTING    PRACTICE    AND    PROCEDURE 

floor  space;  others,  such  as  steam  or  electric  power,  on  the 
basis  of  horse-power  hours  worked;  others  again,  such  as 
general  labor,  on  the  basis  of  the  direct  labor  pay-roll ;  and 
others,  such  as  superintendence  and  general  expenses,  on  the 
basis  of  labor  and  material  costs  combined.  This  main 
division  is  a  comparatively  simple  one,  although  the  circum- 
stances of  each  case  require  careful  study  in  order  to  deter- 
mine the  most  nearly  correct  method ;  and  if  the  industry  is 
such  that  each  department  is  carrying  out  only  one  class  of 
operation,  easily  measured  on  some  unit  basis,  the  division 
of  this  burden  over  unit  costs  presents  few  difficulties.  It 
is  in  cases  where  the  operations  in  a  department  are  of  a 
varied  and  complicated  nature — such,  for  instance,  as  a 
large  machine  shop — that  almost  insuperable  difficulties 
arise;  and  in  such  cases  it  may  well  be  doubted  whether 
any  really  accurate  distribution  is  possible. 

Selling  Costs 

In  considering  the  item  of  overhead  expense,  it  is  neces- 
sary to  emphasize  the  distinction  which  must  be  made  be- 
tween expenses  necessary  for  the  production  of  manufac- 
tured articles  in  a  form  in  which  they  are  ready  for  sale, 
and  the  expenses  incurred  in  offering  them  for  sale  to  the 
public  and  in  carrying  through  the  sales  when  made.  The 
former  item,  as  has  already  been  shown,  is  an  essential  ele- 
ment of  the  cost  of  manufacture;  the  latter  item  is  an  ele- 
ment of  cost  only  from  the  point  of  view  that  without  such 
expense  the  products  could  not  be  sold  and  the  profits  could 
not  be  earned.  Strictly  speaking,  therefore,  these  selling 
expenses  should  be  deducted  from  the  price  ultimately  ob- 
tained for  the  product,  and  the  difference  only  should  be 
considered  as  the  amount  realized  for  the  manufactured 
article.  In  practice  this  same  result  is  often  achieved  in 
a  different  way  by  distinguishing  between  manufacturing 


PROBLEMS    IN    COST    ACCOUNTING  199 

cost  and  selling  cost;  manufacturing  cost  alone  being 
employed  for  the  purpose  of  valuing  the  product  which 
remains  on  hand  unsold  at  the  time  of  taking  an  annual 
inventory,  and  selling  cost  being  dealt  with  only  in  memo- 
randum form,  in  order  that  those  engaged  in  selling  the 
products  may  know  the  limit  below  which  they  should  not 
be  disposed  of. 

Importance  of  Accurate  Cost  Keeping 

The  necessity  for  accurate  cost  keeping  by  commercial 
enterprises  lies  in  the  fact  that  without  such  cost  keeping, 
whether  it  be  of  a  highly  scientific  nature  or  merely  by  rule 
of  thumb,  it  is  impossible  for  a  manufacturer  to  know 
whether  the  price  at  which  he  decides  to  sell  his  articles  will 
or  will  not  yield  a  profit.  The  objection  to  rule  of  thumb 
methods  is  that  they  are  generally  quite  inaccurate,  except 
where  manufacturing  processes  are  relatively  simple.  In  the 
most  usual  cases,  where  the  process  of  manufacture  is 
divided  over  a  number  of  separate  departments,  each  repre- 
senting a  different  set  of  operations,  any  such  methods  can 
only  lead  to  serious  errors  and  frequently  to  ultimate  loss. 

It  should  be  noted  that,  while  the  ascertainment  of  accu- 
rate costs  is  essential,  it  does  not  necessarily  follow  that  no 
profit  can  be  realized  by  selling  at  a  price  which  appears  to 
be  below  such  cost.  In  any  factory  equipped  for  a  certain 
volume  of  production,  the  overhead  charges  will  remain 
practically  stationary,  whether  the  factory  be  operated  to  its 
full  extent  or  to  only  a  small  proportion  thereof.  It  will 
follow,  therefore,  that  the  unit  cost  of  manufacture,  includ- 
ing overhead  expense,  will  be  much  higher  when  the  factory 
is  partly  operated  than  when  it  is  fully  operated ;  and  conse- 
quently a  manufacturer  can  earn  profits  for  himself  by 
increasing  his  output  and  selling  the  increase  at  a  reasonable 
margin  over  and  above  the  direct  cost  excluding  overhead 


200    ACCOUNTING    PRACTICE    AND    PROCEDURE 

expense,  thereby  reducing  his  unit  costs  and  making  more 
profit  than  he  would  have  made  on  the  smaller  output.  It  is, 
however,  safe  to  say  that  it  would  be  dangerous  to  attempt 
to  carry  out  any  such  procedure  without  an  accurate  knowl- 
edge of  direct,  overhead  and  selling  costs. 

Relation  of  Interest  and  Rent  to  Manufacturing  Cost 

One  of  the  most  important  questions  involved  in  cost 
accounting  has  relation  to  the  propriety  of  including  interest 
and  rent  in  costs  of  manufacture. 

It  must  be  premised  that  the  object  of  the  investment  of 
money  in  any  undertaking  is  to  realize  a  profit.  The  induce- 
ment to  an  individual  to  invest  his  capital  in  an  industry, 
rather  than  in  the  purchase  of  stocks  or  bonds,  is  largely  the 
fact  that  by  so  doing  he  not  only  can  obtain  remuneration 
for  his  own  services,  but  can  also  obtain  a  higher  return  or 
rate  of  interest  on  the  capital  invested,  although  at  the  same 
time  he  takes  increased  risks.  The  old  theory  of  economists 
has  been  that  there  is  a  certain  rate  of  return  on  money 
which  eliminates  all  elements  of  risk,  and  that  this  rate  only 
should  be  termed  interest,  all  additions  thereto  being  con- 
sidered as  compensation  for  the  risk  involved ;  but  no  econo- 
mist has  yet  been  able  to  say  what  this  minimum  rate  is,  and 
even  in  the  case  of  what  is  perhaps  the  lowest  rate  known — 
namely,  that  yielded  by  United  States  Government  bonds — 
it  can  not  be  said  that  the  element  of  risk  is  entirely  absent. 
The  impossibility  of  determining  this  pure  rate  of  interest 
apart  from  risk  goes  to  show  that  there  is  in  effect  no  such 
rate,  but  that  all  returns  upon  money  invested,  whether  in 
bonds  or  stocks  or  other  business  enterprises,  are  the  profits 
realized  on  the  use  of  that  money. 

Nature  of  Commercial  Investments 

Those  who  invest  money  in  business  enterprises  fre- 


PROBLEMS    IN    COST    ACCOUNTING  20I 

quently,  and  in  fact  generally,  make  arrangements  by  which 
they  join  in  partnership  with  others  who  also  wish  to  invest, 
giving  to  these  others  a  share  of  the  resulting  profits  as 
remuneration  for  the  capital  employed.  This  share  is  deter- 
mined by  reference  to  the  risk  which  the  different  parties  to 
the  enterprise  take ;  some  prefer  to  take  security  in  the  shape 
of  a  first  charge  upon  the  whole  property,  and  to  compound 
for  their  share  of  the  profit  by  a  fixed  annual  payment,  this 
fixed  annual  payment  being  that  which  is  commercially 
known  as  interest.  Others  are  willing  to  take  a  somewhat 
greater  risk,  but  do  not  wish  to  take  the  whole  of  it,  and 
they  limit  their  risk  by  taking  for  the  capital  which  they 
contribute  a  preferential  charge  upon  the  earnings  or  profits 
of  the  business,  leaving  the  whole  of  the  balance  available 
for  those  who  take  the  ultimate  risk;  the  remuneration  of 
both  these  classes  being  known  commercially  as  dividends. 
There  is  still  another  class  who  do  not  contribute  capital  in 
the  ordinary  sense  of  the  word,  but  provide  the  business  with 
facilities,  such  as  buildings,  machinery,  etc.,  compounding 
with  their  partners  by  agreeing  to  accept  a  fixed  annual  pay- 
ment in  lieu  of  the  share  of  profits  to  which  their  contribu- 
tion to  the  capital  would  entitle  them ;  such  payments  being 
generally  known  as  rent.  All,  however,  whether  consisting 
of  interest,  dividends  or  rent,  are  merely  a  division  of  the 
profits  resulting  from  the  business,  and  in  the  long  run  can 
only  be  met  out  of  those  profits  either  directly,  or  in  some 
cases,  owing  to  the  nature  of  the  relations  between  the 
different  parties,  by  certain  of  them  suffering  an  actual  loss 
of  a  proportion  of  their  share  of  the  capital  in  order  to  carry 
out  the  bargain  made  with  their  partners. 

Interest  and  Rent  Not  a  Manufacturing  Cost 

The  profit  or  return  consists  of  the  difference  between 
the  sale  price  of  the  product  and  the  cost  of  producing  and 


202    ACCOUNTING    PRACTICE    AND    PROCEDURE 

selling  that  product.  It  is  clear,  therefore,  that  interest  or 
rent,  or  any  other  item  in  the  nature  of  return  upon  capital 
invested,  should  not  form  a  part  of  the  cost  of  product, 
the  ascertainment  of  which  is  a  first  essential  to  the  determi- 
nation of  the  yield  or  return  which  the  business  gives,  and 
out  of  which  the  divisions  of  profits  are  to  be  made. 

It  is  true  that,  as  between  the  contributors  to  capital, 
those  who  take  the  ultimate  risk  may  advance  or  commute 
the  share  of  profits  of  others ;  but  this  is  merely  a  bargain 
between  the  different  classes  of  contributors,  and  should  not 
in  any  way  affect  the  cost  of  product. 

If  interest  and  rent  are  treated  as  cost  of  product,  then 
the  extraordinary  result  is  shown  that  the  cost  of  making 
a  certain  article  (other  things  being  equal)  in  a  business  in 
which  the  contributing  interests  are  divided  between  (a) 
the  owner  of  the  factory,  (b)  the  owner  of  capital  taking  a 
small  risk,  and  (c)  the  owner  of  the  residue  of  the  capital, 
will  be  greater  than  in  an  exactly  similar  case  where  the 
residuary  owner  provides  the  whole  of  the  capital  required. 
It  seems  clear  that  the  relations  between  the  partners  or  con- 
tributors should  not  in  any  way  affect  the  cost  of  the 
product ;  and  furthermore  it  would  not  be  reasonable  that  a 
manufacturer  who  had,  by  hiring  his  factory,  raising  loans, 
sharing  profits  with  his  employees,  and  such  kindred  opera- 
tions, distributed  a  considerable  portion  of  his  profits,  should 
then  raise  his  prices  to  an  amount  in  excess  of  his  neighbor's 
who  had  decided  to  provide  all  his  own  facilities  and  not  to 
share  his  profits  with  anybody. 

The  principle  that  rent  and  interest  are  a  distribution  of 
profits  is  recognized  in  the  form  in  which  railroad  accounts 
are  now  prepared,  where  both  rentals  of  leased  lines  and 
interest  on  borrowed  money  of  all  kinds  are  treated  as  a 
charge  against  the  income  from  operations  after  the  same 
has  been  ascertained — that  is,  as  a  distribution  of  profits. 


PROBLEMS    IN    COST    ACCOUNTING  203 

Rental  Charges 

In  the  case  of  manufacturing  companies  no  such  clear 
recognition  of  this  principle  is  found ;  and  rent  for  factories, 
etc.,  where  paid,  is  treated  as  an  item  of  manufacturing  cost 
or  expense,  while  interest,  an  exactly  similar  item,  is  more 
usually  treated  as  a  charge  against,  or  division  of,  profits. 
This  method  of  charging  rent  as  an  expense  has  led  to  a 
claim  that  it  is  properly  so  treated,  and  that  therefore,  when 
a  manufacturer  owns  his  premises  and  pays  no  rent,  an  esti- 
mated amount  corresponding  to  the  value  of  the  use  should 
be  charged  into  and  considered  as  part  of  the  cost  thereof. 
This  sounds  plausible;  but  it  is  believed  that  a  nearer 
approach  to  theoretical  accuracy  is  to  be  found  in  the  railroad 
practice  of  considering  all  rentals,  at  least  when  there  is  a 
natural  division  between  rent  and  other  service,  as  a  charge 
against  or  division  of  profits. 

The  question  of  rent  serves  to  show  the  dif^culty,  if  not 
impossibility,  in  practice,  of  laying  down  any  hard  and  fast 
rules  based  upon  economic  principles,  which  are  to  so  great ' 
an  extent  theoretical.  Rent  has  so  far  been  considered  only 
as  relating  to  the  provision  of  manufacturing  facilities,  land, 
etc. ;  but  an  industry  exists  in  which  capitalists  erect  build- 
ings, and  let  them  out  in  whole  or  in  part  to  others  for  offices, 
residences,  and  other  purposes  incident  and  necessary  to  busi- 
ness enterprise  of  all  kinds.  Rent  of  a  factory  is  clearly  a 
distribution  of  profit,  but  it  is  difflcult  in  practice  to  make 
the  same  claim  for  office  rents,  and  yet  the  arguments  seem 
almost  identical.  A  general  distinction  may  perhaps  be  made 
between  rent  paid  for  the  use  of  premises  which  form  a 
direct  and  integral  part  of  the  manufacturing  operations, 
and  that  paid  for  premises  which  are  merely  incidental 
thereto ;  and  a  further  distinction  lies  in  the  frequent  inclu- 
sion in  rent  of  a  charge  for  other  services,  such  as  light, 
heat,  cleaning,  or  elevators,  or  for  depreciation,  etc.,  all  of 


204    ACCOUNTING    PRACTICE    AND    PROCEDURE 

which  involve  labor  and  profit,  just  as  these  items  are  in- 
volved in  the  purchase  of  material.  No  general  rule  can  be 
laid  down,  beyond  suggesting  that  wherever  an  item  of  rent 
appears  to  consist  mainly  of  a  direct  division  of  profit,  it 
should  be  so  treated,  and  only  considered  as  part  of  cost 
when  it  seems  to  be  mainly  a  composite  item  of  labor,  mate- 
rial and  profit  representing  service  rendered. 

Difficulties  of  Including  Interest  as  a  Manufacturing  Cost 
Turning  to  another  aspect  of  the  interest  question,  it  is 
necessary  to  consider  what  rate  should  be  adopted  if  it  should 
be  granted  for  the  sake  of  argument  that  interest  should 
be  charged  into  costs.  Is  it  to  be  the  rate  which  should  be 
obtained  on  capital  invested  absolutely  without  risk,  or  is  it 
to  be  the  rate  obtained  by  investments  in  stocks  or  bonds, 
and,  if  so,  of  what  class,  inasmuch  as  the  rates  on  these  vary 
all  the  way  from  2  per  cent  on  United  States  Government 
bonds,  up  to  10  per  cent  and  15  per  cent,  and  even  25  per 
cent  and  more,  on  mining  and  other  investments?  Or  is  it 
to  be  the  reasonable  rate  which  the  particular  business  should 
return  on  the  money  invested  therein?  It  has  been  gener- 
ally assumed  by  the  advocates  of  this  course  that  interest  at 
the  rate  of  5  per  cent  or  6  per  cent  should  be  charged  into 
cost,  but  these  rates  mean  nothing  in  themselves ;  they  have 
no  bearing  whatever  upon  the  particular  industry  or  on  the 
rate  which  money  can  earn  in  specified  investments  outside ; 
they  are  arbitrary  standards  which  those  in  the  commercial 
community  have  set  up  in  their  own  minds.  The  only  rate 
which  could  be  justified  in  argument,  assuming  that  it  be 
correct  to  include  any  interest  at  all,  would  be  the  rate  which 
the  owners  of  the  business  thought  they  ought  to  obtain 
on  the  money  they  had  invested  in  it.  The  adoption  of 
such  a  rate  would  at  once  raise  the  question :  To  whom 
should  the  profit  earned  over  and  above  the  rate  so  charged 


PROBLEMS    IN    COST    ACCOUNTING  205 

belong?  The  argument  would  seem  to  be  that,  inasmuch  as 
the  capitalists  have  charged  into  costs  and  obtained  for  them- 
selves the  rate  which  they  think  they  ought  to  realize  on  the 
whole  business,  the  balance  of  it — which  under  such  pro- 
cedure would  be  called  profit — does  not  belong  to  them  at 
all,  but  to  those  who  purchase  goods  from  them  or  to  the 
general  public  or  the  Government.  This  is  a  conclusion 
which  would  hardly  be  desired  by  any  manufacturer.  The 
impossibility,  therefore,  of  determining  a  rate  which  could 
be  successfully  defended,  affords  another  ground  for  the 
conclusion  that  interest  is  not  a  proper  charge  to  costs. 

Some  advocates  of  the  inclusion  of  interest  in  cost  pro- 
pose only  to  include  interest  on  the  fixed  plant  employed  in 
manufacture;  but  obviously  such  a  course  may  in  many  cases 
be  absolutely  misleading.  If,  of  two  plants  turning  out  the 
same  product,  one  requires  the  employment  of  fixed  assets 
of  a  value  of  $10,000  for  thirty  days,  and  the  other  the 
employment  of  fixed  assets  of  $5,000  for  sixty  days,  the 
interest  charge  introduced  upon  this  principle  will  be  the 
same  in  both  cases,  whereas  the  process  which  takes  sixty 
days  to  complete  will  obviously  involve  a  longer  investment 
of  working  capital.  But  if  an  attempt  is  made  to  allow  for 
interest  both  on  fixed  and  working  capital,  the  adjustment 
will  inevitably  be  a  very  complicated  and  difficult  one  to 
carry  out.  Where  interest  on  fixed  assets  alone  is  consid- 
ered, the  calculation  of  the  charge  is  not  free  from  difificulty. 
The  amount  of  capital  employed  and  the  time  for  which  it 
was  emplayed  may  perhaps  be  easily  determined ;  yet,  unless 
continuous  production  throughout  the  year  is  possible,  the 
interest  charge  based  thereon  will  be  inadequate,  and  any 
calculation  to  be  correct  must  allow  for  the  time  during 
which  the  plant  will  normally  be  unemployed. 

Some  confusion  in  relation  to  the  items  of  rent  and 
interest  is  found  in  the  relation  of  the  profits  of  a  corpora- 


2o6      ACCOUNTING    PRACTICE    AND    PROCEDURE 

tion  or  an  individual  to  the  profits  of  the  business  which  is 
carried  on.  The  latter  should  be  identical  under  the  same 
conditions  of  manufacture,  whatever  the  financial  arrange- 
ments may  be,  but  the  former  are  affected  materially  by  the 
share  of  such  profits  which  is  distributed  to  others  in  the 
shape  of  rent  and  interest,  as  well  as  in  commission  or  other 
payments  dependent  in  any  way  upon  profits.  The  inclusion 
of  these  distributions  as  a  charge,  before  determining  the 
ultimate  profit  accruing  to  the  corporation  or  the  individual 
manufacturer,  does  not  thereby  justify  their  treatment  as 
part  of  the  cost  of  product. 

Suggested  Treatment  of  Interest  in  Connection  with  Costs 

Although  it  cannot  be  conceded  that  interest  is  a  proper 
element  in  the  cost  of  product,  there  is  an  undoubted  demand 
for  some  form  of  statement  which  will  give  effect  to  the 
interest  element,  at  any  rate  for  comparative  and  statistical 
purposes. 

The  most  usual  objects  sought  may  be  grouped  into 
three  classes: 

(1)  Cases  in  which  the  lapse  of  time  is  a  necessary 
part  of  the  cost  of  production,  and  materials  consequently 
have  to  be  stored  for  long  periods  while  a  seasoning  pro- 
cess is  completed,  e.  g.,  lumber  or  tobacco. 

(2)  Cases  in  which  it  is  desired  to  give  effect  to  varia- 
tions in  the  amount  of  capital  employed  and  the  term  of 
employment  in  the  production  of  different  articles,  or  the 
same  articles  by  different  methods  or  factories. 

(3)  Cases  in  which  capital  is  expended  in  additional 
facilities  with  the  view  of  cheapening  cost  of  production, 
and  it  is  desired  to  set  off  the  interest  on  the  new  capital 
against  the  savings  effected. 

In  the  first  case,  there  is  a  substantial  and  necessary  lapse 
of  time  between  the  purchase  of  materials  and  the  date  when 


PROBLEMS    IN    COST    ACCOUNTING  207 

they  become  useful  or  productive — as,  for  instance,  in  the 
case  of  seasoning  lumber;  and  the  selling  value  of  the 
product,  apart  from  market  fluctuations,  increases  by  reason 
of  the  lapse  of  time  to  an  amount  more  than  sufficient  to 
provide  for  an  interest  charge.  The  arguments  already 
adduced  apply  equally  against  treating  as  part  of  cost,  any 
interest  that  may  accrue  on  money  borrowed  for  the  pur- 
pose of  carrying  the  product  until  it  matures.  In  fact,  the 
stockholders,  in  compounding  with  the  lenders  for  interest 
at  a  fixed  rate  payable  at  a  fixed  time,  have  in  effect  made 
an  advance  out  of  their  share  of  the  profits  pending  realiza- 
tion ;  and  while  this  advance  can  not  properly  be  treated  as 
part  of  the  cost,  it  may,  as  an  asset,  properly  be  carried  for- 
ward as  a  deferred  charge  against  profits  under  the  category 
of  working  assets. 

In  the  other  cases,  the  correct  way  of  arriving  at  the 
desired  result  is  not  to  charge  into  the  cost  interest  at  an 
arbitrary  rate — which  means  little  or  nothing — but  to  com- 
pare the  margin  between  the  sale  and  cost  price,  or  in  other 
words  the  return  upon  each  product,  with  the  capital 
invested,  in  order  to  secure  that  return.  This  comparison 
would  be  a  true  one,  would  show  exactly  how  much  the 
capital  invested  really  earned,  and  would  be  a  good  guide  as 
to  whether  too  much  or  too  little  capital  was  invested. 
Moreover,  the  adoption  of  the  arbitrary  rate  defeats  its  own 
object,  for,  according  as  the  rate  adopted  varies  from  the 
true  rate,  if  there  be  such,  so  the  comparisons  deduced  from 
the  results  will  be  erroneous.  If  the  capital  invested  in  a 
mercantile  business  should  yield  from  15  per  cent  to  20 
per  cent  on  the  investment,  then  it  is  clearly  erroneous  to 
say  that  the  operations  resulting  from  the  use  of  a  certain 
machine,  in  which  a  certain  definite  proportion  of  that  capital 
had  been  invested,  should  be  charged  with  interest  on  that 
capital  at  5  per  cent,  or  6  per  cent,  or  some  other  rate  entirely 


2o8    ACCOUNTING    PRACTICE    AND    PROCEDURE 

different  from  that  which  it  is  really  expected  to  yield.  As 
between  two  different  kinds  of  machines  used  to  produce  the 
same  product,  but  having  different  capital  values,  the  con- 
clusion reached  by  comparing  the  cost  including  interest  at 
5  per  cent  will  be  entirely  different  from  the  conclusion 
reached  by  including  interest  at  lo  per  cent,  and  neither  of 
these  rates  will  be  anything  more  than  a  guess. 

Statistical   Comparisons  between  Production  and  Capital 
Invested 

The  demand  for  statistical  statements  of  comparison 
between  production  and  capital  invested  requires  considera- 
tion of  the  following  factors  involved  in  profits : 

(i)   The  labor,  material  and  expense  cost  of  a  unit  of 
each  class  of  article; 

(2)  Facilities  used  in  manufacture,  such  as  land,  build- 

ings, machinery,  tools,  stocks  on  hand  and  other 
working  capital,  all  segregated  between  the  differ- 
ent classes  of  articles ; 

(3)  The  time  during  which  such  facilities  are  in  use  for 

a  unit  of  each  class; 

(4)  The  selling  price  of  each  unit  of  each  class. 

If  these  elements  be  known,  comparisons  can  be  made 
between  different  articles  produced  in  the  same  factory,  or 
between  the  same  articles  produced  in  different  factories, 
as  to  the  amount  of  fixed  capital  employed  in  different 
processes,  and  the  time  for  which  it  is  employed;  as  to  the 
amount  of  working  capital  constantly  maintained  and  used ; 
and  as  to  the  effect  of  further  expenditures  on  additions 
and  improvements  with  a  view  to  cheapening  cost  of  pro- 
duction. The  first  of  the  above  four  factors  should  alone 
enter  into  the  general  accounting  books  and  form  the  basis 
of  inventory  valuations,  and  so  of  the  actual  profits  earned ; 


PROBLEMS    IN    COST    ACCOUNTING  209 

the  remaining  factors  should  be  dealt  with  only  in  subsidiary- 
statistical  records.  The  difiference  between  the  sum  of  all 
selling  prices  (4)  and  of  all  costs  (i)  will  agree  with  the 
gross  profit  in  the  accounting  books;  and  a  comparison  of 
this  figure  with  the  total  capital  employed,  including  not  only 
fixed  but  circulating  capital  necessary  for  manufacturing 
purposes,  will  give  the  rate  of  return  yielded  by  all  classes 
of  articles.  The  cause  of  any  variation  in  this  rate  of  return, 
as  compared  with  a  previous  period,  or  of  the  varying  rates 
of  return  on  different  articles  in  the  same  factory,  or  of  the 
same  articles  in  different  factories,  will  be  obtained  from  the 
detail  figures.    Such  variations  may  be  due  either  to — 

( 1 )  Higher  or  lower  cost  of  labor,  material  and  expense ; 

(2)  Greater  or  smaller  amount  of  facilities  used; 

(3)  Longer  or  shorter  time  during  which  these  facilities 

are  used; 

(4)  Lower  or  higher  selling  price. 

If  interest  at  an  arbitrary  rate  is  included  throughout  in 
labor,  material  and  expense  costs,  it  means  that  the  fluctua- 
tions in  profit  due  to  the  first  three  of  these  variations  are 
merged  into  one  and  can  not  without  considerable  labor  be 
again  segregated.  The  best  measure  of  factors  (2)  and  (3) 
would  seem  to  be  the  value  of  the  facilities  used,  multiplied 
by  the  fraction  of  the  year  during  which  they  were  used,  and 
divided  by  100,  which  product  would  be  equivalent  to  interest 
at  I  per  cent  per  annum ;  the  actual  margin  between  selling 
price  and  cost  of  labor,  material  and  expense  divided  by  this 
product,  would  thus  be  the  actual  rate  of  return  yielded  by 
any  particular  class  of  articles,  the  average  of  such  yields 
corresponding  to  the  yield  shown  by  the  principal  accounting 
records. 

Unused  facilities  would  under  this  system  appear  as  a 
factor  in  reducing  profits,  either  by  lack  of  sufficient  business 


2IO   ACCOUNTING    PRACTICE    AND    PROCEDURE 

to  employ  them,  or  by  excess  facilities  in  one  portion  of  the 
plant  as  compared  with  another.  The  product  factor  corre- 
sponding to  these  unused  facilities  would  form  part  of  the 
divisor  in  obtaining  the  average  yield. 

Comparative  costs  of  separate  operations  will  be  reached 
by  a  consideration  not  only  of  the  actual  labor,  material  and 
expense  cost  in  different  periods  or  in  separate  factories,  but 
also  by  a  comparison  of  these  costs  with  the  facilities  em- 
ployed. Thus  the  estimated  savings  to  be  effected  in  any 
operation  by  additional  expenditures  on  construction 
account,  should  be  found  reflected  in  the  reduced  cost  of 
these  operations. 

Such  a  plan  as  that  here  suggested  gives  proper  weight 
to  all  the  factors  entering  into  profits  without  introducing 
any  arbitrary  rate  of  interest;  it  will  be  no  more  complicated 
in  its  working  than  are  cost  systems  which  are  in  constant 
use,  and  its  complications  will  vary  with  the  number  of 
different  articles  produced  for  which  separate  costs  are 
required. 

Profit-Sharing  in  Its  Relation  to  Costs 

The  question  is  frequently  raised  whether  distribution 
of  profits  made  to  employees  under  profit-sharing  schemes, 
or  contributions  to  special  funds,  for  their  benefit,  are  proper 
items  to  include  as  part  of  manufacturing  costs.  This  ques- 
tion must  be  answered  in  the  negative.  Labor  has  already 
received  its  subsistence,  and  this  is  properly  included  as  cost ; 
any  further  distribution  to  labor,  whether  by  way  of  a  share 
of  profit  or  a  provision  for  old  age  or  sickness,  unless  it  be  a 
contractual  or  compulsory  payment  entirely  independent  of 
profits,  represents  a  further  share  of  labor  in  the  profit. 
Contractual  and  compulsory  payments  not  dependent  on 
profits,  compensation  for  accidents  and  casualties  arising  in 
the  course  of  manufacture,  and  pensions  to  retired  employees 


PROBLEMS    IN    COST    ACCOUNTING  211 

are,  however,  clearly  proper  elements  of  cost.  All  voluntary 
distributions  to  labor  not  called  for  by  contract  or  law,  or 
arising  directly  out  of  the  process  of  manufacture,  must  be 
considered  as  a  further  share  in  profits  given  to  labor. 

Cost  as  a  Price  Basis 

Contracts  are  frequently  entered  into  on  the  terms  that 
the  price  is  to  be  fixed  at  actual  cost  plus  a  percentage 
thereon,  and  disputes  sometimes  arise  as  to  what  constitutes 
cost.  These  disputes  are  almost  always  due  to  carelessly 
drawn  contracts,  the  parties  thereto  and  their  legal  advisers 
frequently  having  a  very  loose  idea  of  the  principles  in- 
volved. The  importance  of  a  clearly  drawn  contract  is  evi- 
dent, in  view  of  the  conflicting  views  on  such  subjects  as 
rent,  interest,  bonuses,  commissions  to  employees,  and  many 
other  similar  items;  and  if  a  proper  form  of  contract  exists 
no  dispute  is  likely  to  arise.  In  the  contrary  case,  however, 
the  elementary  principles  of  costs  may  be  relied  upon  to  solve 
the  difficulty.  If  a  manufacturer  enters  into  such  a  contract, 
it  must  be  assumed  that  he  has  all  the  facilities  necessary  for 
carrying  it  out,  and  no  charge  for  the  use  of  those  facilities, 
other  than  actual  wear  and  tear  and  depreciation  thereof  in 
the  course  of  carrying  out  the  contract,  can  be  allowed  as  an 
item  of  cost.  Similarly,  no  charge  can  be  allowed  for  rent 
or  interest,  or  other  items,  which,  according  to  the  theory 
laid  down,  represent  a  share  of  profits  on  the  operations.  It 
is  on  these  items  that  disputes  generally  arise,  rather  than  on 
the  more  complicated  questions  of  proper  distribution  of 
burden,  upon  which  manufacturers  and  contractors  are 
usually  much  better  informed. 


CHAPTER  X 

THE  DUTIES  AND  RESPONSIBILITIES  OF  THE 
PUBLIC  ACCOUNTANT 

In  preceding  chapters  a  statement  of  accounting-  prin- 
ciples and  methods  has  been  set  forth,  and  it  has  clearly 
appeared  that  in  order  to  insure  their  correct  application  a 
careful  study  must  be  made  of  all  the  facts  in  each  particular 
case.  This  critical  examination  is  commonly  undertaken  by 
the  public  accountant,  who  is  qualified  for  this  purpose  by 
his  training  and  experience,  and  who  undertakes  certain 
duties  and  responsibilities  in  interpreting,  advising  upon,  and 
certifying  to  statements  of  account  for  various  purposes. 

These  duties  and  responsibilities  may  be  divided  as 
follows : 

( 1 )  Those  in  respect  of  the  prospectus,  or  the  prepara- 
tion and  certification  of  accounts  of  past  results  for  the  pur- 
pose of  the  sale  of  a  business  or  the  issue  of  new  securities. 

(2)  Those  in  respect  of  audit,  or  the  examination,  audit, 
and  certification  of  the  annual  statements  of  accounts. 

(3)  Those  in  respect  of  liquidation  and  reconstruction, 
involving  the  preparation  of  statements  and  reports  upon 
the  condition  of  a  business  which,  by  reason  of  financial 
difficulties,  is  put  into  bankruptcy  or  into  the  hands  of  a 
receiver;  and  the  preparation  of  further  statements  and 
reports  for  the  purpose  of  its  reorganization. 

212 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    213 

( I )  In  Respect  of  the  Prospectus 
Necessity  for  Accountants'  Certificates 

The  application  to  the  pubhc  to  subscribe  to  stocks  and 
bonds  of  a  corporation  is  generally  termed  a  "prospectus." 
In  Great  Britain,  where  the  value  of  the  services  of  public 
accountants  is  more  generally  recognized,  it  is  the  almost 
universal  custom  that  the  prospectus  should  contain  a  certifi- 
cate by  a  chartered  accountant  as  to  the  earnings  of  a  period 
of  years,  and  frequently  also  as  to  the  financial  position. 

In  this  country  this  certificate  is  still  frequently  replaced 
by  a  letter  from  the  vendors,  or  from  the  president  or  direct- 
ors of  the  corporation,  or  from  the  bankers  who  recommend 
the  investment,  stating  the  results  of  operations  and  the 
present  condition.  As  has  been  already  shown,  the  questions 
involved  in  the  determination  of  profits  are  often  highly 
technical;  those  relating  to  the  proper  valuation  of  inven- 
tories at  the  beginning  and  end  of  any  specified  period,  the 
provision  made  for  maintenance  and  repairs,  and  the  distinc- 
tion between  renewals,  improvements  and  construction,  are 
of  vital  importance ;  and  a  departure  from  correct  principles 
in  these  and  other  matters  may  easily  make  what  is  really 
a  losing  business  appear  as  a  comparatively  profitable  one. 

The  proprietors  or  chief  officers  of  the  vendor  concern 
must  to  a  large  extent  rely  upon  their  subordinates  for  the 
facts  which  they  furnish  to  the  bankers  or  to  the  public. 
They  have  not,  as  a  rule,  the  necessary  skill  in  accountancy 
to  detect  errors,  whether  of  principle  or  of  detail,  in  the 
statements  submitted  to  them ;  they  do  not  properly  appre- 
ciate the  distinction  between  facts  and  estimates,  which 
might  perhaps  be  more  properly  described  as  "expert 
guesses" ;  and  finally,  they  are  interested  in  putting  the  best 
possible  complexion  upon  the  general  state  of  affairs,  and 
will  naturally,  and  not  necessarily  improperly,  be  biased  in 


214   ACCOUNTING    PRACTICE    AND    PROCEDURE 

cases  of  doubt  in  favor  of  the  view  which  is  most  to  their 
own  interests. 

The  main  desire  of  some  bankers  has  been  to  sell  the 
stocks  or  bonds  which  they  are  offering  to  the  public,  and 
make  a  quick  profit  on  the  turnover.  Their  reputation  and 
standing  requires  them  to  take  every  reasonable  precaution 
to  satisfy  themselves  that  the  investment  they  are  offering 
is  a  thoroughly  sound  and  reliable  one ;  and  while  it  is  doubt- 
ful if  letters  from  or  facts  supplied  by  the  vendors  are  suffi- 
cient precautions,  yet,  as  long  as  the  public  demands  no 
more,  there  is  no  reason  why  bankers  should  offer  more. 
In  the  meantime  the  natural  bias  of  the  promoter  helps  the 
banker  with  a  favorable  statement,  and  the  verification  by 
a  public  accountant  might  show  a  less  favorable  condition 
and  diminish  the  banker's  profit.  It  may  be  added  that  the 
neglect  of  such  obvious  precautions  by  the  honest  promoter 
makes  the  task  of  the  dishonest  one  comparatively  easy, 
and  in  the  interests  of  commercial  morality  and  for  the 
better  protection  of  the  public  it  is  interesting  to  note  that 
a  change  is  in  progress  in  this  respect,  and  that  the  certificate 
of  a  reputable  public  accountant  is  becoming  a  much  more 
common  feature  in  prospectuses,  and  will  no  doubt  soon  be 
as  universal  here  as  in  Great  Britain. 

English  Requirements  as  to  Prospectuses 

The  English  practice,  with  reference  to  the  issue  of 
prospectuses,  is  worth  a  reference.  Under  the  English  Com- 
panies (Consolidation)  Act,  1908,*  every  company  inviting 
subscriptions  for  capital  is  required  to  file  with  the  Registrar 
of  Joint-Stock  Companies  a  copy  of  its  prospectus,  or,  if 
there  is  no  prospectus,  a  statement  in  lieu  of  the  prospectus, 
containing  the  following,  among  other  information :  the 
names  and  addresses  of  the  directors;  the  minimum  sub- 


*See  Appendix  III. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    215 

scription  upon  which  the  company  may  proceed  to  allot- 
ment; the  names  and  addresses  of  the  vendors  of  the 
propeity  purchased  or  proposed  to  be  purchased  or  acquired; 
the  purchase  price,  distinguishing  the  amount  paid  for  good- 
will; the  amount  of  commission  payable  for  procuring  sub- 
scriptions for  any  of  the  capital  offered  for  subscription ;  the 
estimated  amount  of  the  preliminary  expenses ;  the  amount 
paid  or  to  be  paid  to  any  promoter,  and  the  consideration 
for  such  payment ;  the  dates  of  and  parties  to  every  material 
contract,  and  the  time  and  place  at  which  such  contracts 
may  be  inspected ;  the  names  and  addresses  of  the  auditors ; 
and  particulars  of  the  nature  and  extent  of  the  interest  of 
every  director  in  the  promotion  of  the  company  or  in  the 
property  proposed  to  be  acquired.  In  addition,  it  is  the 
regular  practice  in  all  cases,  except  that  of  an  entirely  new 
business  not  yet  established,  to  incorporate  in  the  prospectus 
a  certificate  of  a  chartered  accountant,  as  to  the  earnings  for 
a  period  of  years,  and  frequently  as  to  the  value  of  the  net 
current  assets,  where  these  are  to  be  taken  over. 

The  Act  also  provides,  in  Section  84,  that  every  director 
or  promoter,  or  other  person  who  has  authorized  the  issue 
of  the  prospectus,  shall  be  liable  to  pay.  compensation  to  all 
persons  subscribing  for  shares  on  the  faith  of  the  prospectus, 
for  any  loss  or  damage  they  may  have  sustained  by  reason 
of  any  untrue  statement  therein,  unless  it  is  proved  that 
there  was  reasonable  ground  for  believing  such  a  statement 
to  be  true ;  or,  if  based  on  a  report  of  an  expert,  that  it  fairly 
represented  such  report  and  that  those  responsible  for  the 
prospectus  had  reasonable  ground  for  believing  that  the 
expert  was  competent  to  make  the  report. 

Period  to  be  Covered  by  Prospectus 

In  addition  to  such  accounting  questions  as  are  directly 
involved  in  the  determination  of  profits,  there  are  others  of 


2l6   ACCOUNTING    PRACTICE    AND    PROCEDURE 

equal,  if  not  greater,  importance  to  which  due  attention 
must  be  given  if  the  prospectus  is  to  fully  disclose  to  the 
intending  investor  all  the  material  facts  necessary  to  enable 
him  to  form  a  judgment  upon  the  value  of  the  securities 
offered  to  him. 

Perhaps  the  most  important  preliminary  matter  for  de- 
cision is  the  period  for  which  results  should  be  given  in  the 
prospectus.  Those  of  one  year,  especially  if  that  year  hap- 
pened to  be  an  exceptionally  good  one,  can  under  no  cir- 
cumstances be  considered  a  fair  basis.  Generally  it  may  be 
said  that  the  longer  the  period  taken,  the  better,  with  the 
qualification  that  the  results  should  be  brought  down  to  a 
date  as  close  to  the  publication  of  the  prospectus  as  the 
circumstances  will  permit,  and  that  greater  prominence 
should  be  given  to  those  of  the  last  three  or  five  years.  It 
has  frequently,  happened  that  an  undertaking  has  been 
offered  for  sale  just  at  the  zenith  of  its  prosperity,  or  even 
just  after  the  tide  has  turned  and  it  is  commencing  to  show 
less  satisfactory  results,  so  that  figures  of  past  profits  were 
not  a  fair  criterion  of  future  prospects.  On  the  other  hand, 
owing  to  general  depression  of  trade  or  other  special  causes 
— such  as  excessive  competition — which  will  be  avoided 
under  the  scheme  proposed,  it  may  have  shown  within  the 
last  year  results  which  are  less  than  a  fair  measure  of  its 
earning  capacity.  The  responsibilities  thrown  upon  the 
accountant  are  thus  onerous.  He  must  consider  that  his 
duties  are  primarily  to  the  investor,  and  must  be  careful 
that  the  years  selected  and  the  manner  in  which  the  results 
of  these  years  are  grouped  will  disclose  the  real  facts ;  and 
yet  in  so  doing  he  must  remember  that  he  has  a  duty  also 
to  the  vendor,  and  must  not  make  his  selection  in  such  a 
manner  as  to  reflect,  as  permanent,  conditions  which  are 
really  temporary.  Generally  it  may  be  said  that  no  period 
of  less  than  three  years  can  usually  be  considered  as  giving 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    217 

a  fair  basis,  and  that  one  of  five  years  is  better ;  and  while  the 
results  of  a  longer  period  are  always  a  useful  guide  to  the 
past  history  of  the  undertaking,  they  are  not  such  a  good 
indication  of  the  actual  condition  at  the  present  time. 

Treatment  of  Unusual  Profits  or  Losses 

In  setting  forth  the  results  it  is  imperative  that  extraor- 
dinary profits  or  losses  not  arising  out  of  operations  nor  in 
the  ordinary  course  of  business,  such,  for  instance,  as  those 
resulting  from  sales  of  portions  of  capital  assets,  should  be 
either  eliminated  or  stated  separately.  Particularly  should 
regard  be  had  to  any  contracts  or  other  arrangements  in 
force  during  the  period  examined  resulting  in  excessive 
profits  or  excessive  losses,  which,  from  the  fact  that  these 
contracts  or  arrangements  have  since  been  terminated,  may 
not  recur.  Such  profits  or  losses  should  either  be  eliminated 
or  separately  stated ;  but  which  of  these  two  courses  should 
be  adopted  must  depend  upon  the  probability  or  possibility 
that  similarly  extraordinary  results  may  be  realized  in  the 
future.  If,  for  instance,  while  certain  profitable  contracts 
have  terminated,  other  similar  ones  promising  good  results 
have  actually  been  secured,  it  would  not  be  fair  to  the  vendors 
to  exclude  the  profits  realized  from  the  former.  And  if  the 
business  is  one  that  depends  to  a  very  large  extent  upon 
contracts,  and  there  is  no  sign  of  any  falling  off  in  those  on 
hand  and  not  commenced,  it  would  probably  not  be  neces- 
sary  even  to  state  the  results  separately. 

Fluctuations  of  Profits 

A  further  point  of  considerable  importance  to  the  pros- 
pective investor  is  that  he  should  know  whether  the  profits 
for  the  period  covered  by  the  examination  have  remained 
steady,  have  increased  or  decreased  steadily,  or  have  been 


2l8    ACCOUNTING    PRACTICE    AND    PROCEDURE 

characterized  by  extreme  fluctuations.  For  this  reason  the 
certificate  should  always  show  the  results  of  each  year  sepa- 
rately, at  any  rate  for  the  last  three  or  five  years,  and  on  no 
account  should  the  average  profits  only  be  stated,  unless  for 
some  reason — which  is  disclosed  in  the  certificate — the 
profits  of  separate  years  cannot  be  ascertained.  Where  the 
profits  may  have  shown  a  gradual  falling  off,  or  those  of  the 
latest  years  are  below  the  average,  it  would  be  most  improper 
that  the  certificate  should  give  the  average  without  stating 
the  actual  facts  year  by  year.  From  the  investor's  point  of 
view  a  certificate  in  the  prospectus  stating  merely  the  aver- 
age profits  for  a  certain  period  of  years  should  be  mis- 
trusted, on  the  ground  that  if  the  business  were  a  progressive 
one  and  there  were  in  fact  nothing  to  conceal,  the  promoters 
would  always  prefer  to  get  the  fullest  possible  benefit  from 
that  fact  by  stating  the  results  of  each  year  separately;  if 
this  course  is  not  adopted  it  may  be  presumed  that  there  is 
good  reason  for  concealment  from  the  promoter's  point  of 
view. 

It  frequently  happens,  owing  to  delay  in  completing 
arrangements,  that  a  considerable  time  elapses  between  the 
date  up  to  which  the  profits  are  certified  and  that  of  the 
accountant's  certificate  and  the  issue  of  the  prospectus.  In 
such  cases  it  is  certainly  the  accountant's  duty  to  take  all 
reasonable  steps  to  satisfy  himself  that  nothing  has  happened 
in  the  interim  to  throw  any  doubt  upon  the  continuance  of 
the  results  to  which  he  has  certified.  For  instance,  if  in  a 
period  of,  say,  six  months  so  elapsing  the  books  should 
clearly  show  a  serious  diminution  of  profits,  or  even  a  loss, 
this  is  a  material  fact  which  the  accountant  might  and  should 
ascertain  if  he  used  due  diligence,  and  which,  under  any 
ordinary  circumstances,  should  be  disclosed  in  his  certificate. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    219 

Results  for  Broken  Periods 

Just  as  it  is  improper  to  average  the  results  of  several 
years,  so  it  is  equally  improper  to  average  the  results  of  a 
portion  of  a  year  to  make  up  a  complete  year.  Many  busi- 
nesses are  essentially  of  a  seasonal  character,  and  the  results 
of  the  first  six  months,  for  instance,  may  be,  normally, 
entirely  different  from  those  of  the  last  half  of  the  calendar 
year ;  and  even  when  the  business  is  continuous  through  the 
year  it  is  not  safe  to  assume  that  the  profits  of,  say,  two 
unexpired  months  will  equal  the  average  of  the  previous  ten. 
In  dealing  with  such  broken  periods  it  is  preferable,  if 
possible,  to  give  also  the  corresponding  figures  for  the  same 
period  in  the  preceding  year,  so  as  to  show  the  comparative 
increase  or  decrease. 

Interest  in  Its  Relation  to  Profits 

A  problem  of  considerable  difficulty  in  determining  the 
profits  for  a  prospectus,  is  the  proper  treatment  of  interest 
paid  on  loans,  borrowed  money,  or  partners'  capital.  Speak- 
ing generally,  it  may  be  said  that  interest  in  whatever  shape 
is  profit;  and  that  if  the  profit  of  carrying  on  a  particular 
undertaking  is  to  be  ascertained,  all  interest  paid  out  on 
money  employed  in  the  business  should  be  treated  as  part 
of  the  profits  of  the  undertaking,  and  similarly  all  interest 
received  on  any  proportion  of  the  capital  which  may  from 
time  to  time  be  invested  in  outside  securities  should  be 
excluded  therefrom.  But  in  certifying  results  for  a  pros- 
pectus regard  must  be  had  to  the  conditions  under  which 
the  capital  required  for  the  purposes  of  the  business  is  to  be 
raised  in  future.  If  the  amount  to  be  provided  is  at  least 
equal  to  the  maximum  borrowed  in  the  past,  then  the  whole 
of  the  profits  before  deducting  interest  charges  will  be 
available  for  dividends  or  interest  on  such  capital.  If,  on 
the  other  hand,  it  is  proposed  to  provide  a  portion  only  of 


220    ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  average  amount  borrowed  in  the  past,  it  will  be  neces- 
sary, in  putting  the  results  before  an  investor,  to  deduct 
therefrom  the  interest  on  the  borrowed  money  employed  in 
earning  those  profits  in  excess  of  that  which  the  promoters 
intend  to  provide;  for  the  new  concern  would  then  have 
to  borrow  the  difference  from  bankers  or  others  and  pay 
interest  on  the  money  so  borrowed,  before  any  distribution 
of  profits  was  made  to  those  providing  the  capital  called 
for  in  the  prospectus.  It  is  perhaps  hardly  necessary  to  add 
that  interest  on  partners'  capital  in  a  private  partnership  is 
essentially  a  part  of  the  profits  of  the  business — subject  to 
the  above  remarks  when,  as  is  hardly  likely,  a  smaller 
amount  of  capital  is  to  be  provided  in  future.  In  every  case 
the  certificate  given  should  state  clearly  how  interest  has 
been  treated. 

Salaries  as  Affecting  Profits 

The  treatment  of  salaries  that  have  been  or  may  have  to 
be  allowed  to  the  partners  or  chief  managers  of  the  busi- 
ness is  another  matter  of  importance.  In  a  private  partner- 
ship, or  in  a  corporation  in  which  the  managers  are  the  chief 
or  only  stockholders,  it  frequently  happens  either  that  they 
have  drawn  no  salaries,  or  only  small  ones  compared  to  the 
market  value  of  the  services  rendered;  a  reason  being  that 
the  managers  may  prefer  to  take  their  remuneration  in  the 
shape  of  profits  entirely,  rather  than  to  consider  them  a 
charge  against  the  business  before  ascertaining  such  profits. 
If,  therefore,  the  profits  be  certified  without  any  provision  for 
the  salaries  of  those  responsible  for  the  general  management 
in  the  past,  it  is  clear  that  the  resulting  profits  to  the  new 
concern  must  be  materially  less  than  those  certified  to. 
Consequently,  it  is  always  necessary  either  to  specify  that 
no  provision  has  been  made  for  the  remuneration  of  future 
managers,  or  to  include,  as  a  charge  against  the  profits 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    221 

certified,  whatever  amounts  are  contemplated  or  contracted 
for  in  the  future. 

Depreciation  and  Renewals  in  Their  Relation  to  Profits 

An  important  factor  in  connection  with  the  prospectus 
is  the  imperative'  necessity  of  stating  in  the  certificate  as  to 
profits  whether  full  provision  for  depreciation  and  accruing 
renewals  has  or  has  not  been  made.  While  it  is  easy  to  lay 
down  this  principle,  it  is  perhaps  one  of  the  most  difficult 
matters  to  determine  in  practice,  by  reason  of  the  frequently 
imperfect  state  of  the  records  and  often  of  the  entire  absence 
of  reliable  figures  of  original  cost,  or  even  of  any  proper 
distinction  between  expenditures  on  improvements,  additions 
and  renewals.  In  a  private  business  run  on  conservative 
lines,  a  large  proportion  of  the  earnings  may  be  put  back  into 
the  property  in  the  way  of  improvements  and  betterments; 
and  if  the  operations  have  been  of  a  highly  profitable  nature 
large  amounts  are  frequently  charged  off  from  time  to  time 
in  reduction  of  capital  outlays.  So  far  as  the  latter  items 
are  concerned,  it  is  easy  for  the  accountant  to  separate  them 
and  adjust  his  statement  of  earnings  accordingly,  but  where 
improvements  and  betterments  have  been  effected  as  part 
of  the  ordinary  operations  of  the  plant,  and  charged  into 
maintenance  and  repairs  almost  from  day  to  day,  it  becomes 
practically  impossible  at  a  subsequent  date  to  separate  them 
from  the  proper  maintenance  charges.  Such  a  practice  can 
not  be  too  strongly  condemned,  not  only  as  concealing  the 
true  facts  and  making  the  position  appear  worse  than  it 
really  is,  but  also,  from  the  point  of  view  of  the  vendor, 
because  the  impossibility  of  adding  such  expenditures  back 
to  earnings  must  result  in  his  receiving  a  lower  price  for  his 
goodwill,  based  on  earning  capacity,  than  he  otherwise 
would.  The  mere  claim  by  a  vendor  that  large  expenditures 
have  been  so  made  and  charged,  without  a  shred  of  support- 


222    ACCOUNTING    PRACTICE    AND    PROCEDURE 

ing  evidence  in  the  books  as  to  the  cost  of  such  improve- 
ments, or  even  of  the  fact  that  they  have  been  made,  cannot 
be  accepted  by  the  accountant;  it  then  becomes  a  question 
whether  he  can  satisfy  himself  that  the  expenditures  so 
charged,  which  were  not  directly  ascertainable,  have  been 
sufficiently  large  to  take  the  place  of  depreciation;  and  it 
will  readily  be  seen  that  this  is  a  most  difficult  question, 
involving  great  experience  and  careful  judgment. 

Varying  Requirements  of  Statements  of  Profits 

It  should  here  be  noted  that  there  may  be  a  marked 
difference  between  a  statement  of  profits  prepared  for  and 
certified  to  an  annual  meeting  of  stockholders,  and  one 
that  is  prepared  for  the  purpose  of  showing  to  prospective 
investors  the  earning  capacity  of  the  business.  In  the  former 
case  the  accounts  are  adopted  by  the  stockholders  at  each 
annual  meeting,  reserves  of  various  kinds  are  made  from 
the  profits  of  good  years  to  be  carried  forward  to  bad  years, 
changes  in  methods  of  valuations  of  different  classes  of 
assets  are  made  from  year  to  year,  and,  generally,  the  ac- 
counts are  drawn  up  more  with  a  view  of  determining  the 
amount  which  can  safely  be  divided  among  the  stockholders 
in  dividends,  than  of  showing  the  actual  earning  capacity  of 
the  business.  In  the  latter  case,  however,  it  is  essential  that 
the  profits  certified  for  each  separate  year  be  those  actually 
earned  from  the  operations  of  that  year — any  arbitrary 
additions  or  deductions  due  to  changes  in  bases  of  valua- 
tions or  otherwise  being  excluded — and  that  they  be  free 
also  from  abnormal  fluctuations  due  to  unavoidable  con- 
tingencies, which  should  be  provided  for  proportionately 
over  a  period  of  years. 

Adjustments 

All  adjustments  must  be  made  that  may  be  necessary  to 
insure  that  the  accounts  fairly  represent  the  results  of  each 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    223 

separate  period.  It  may  happen  that  the  vendor  may  offer  to 
guarantee  the  value  of  certain  assets,  or  a  maximum  amount 
for  the  liabihties.  Such  a  guarantee  is  of  value  only  to  a 
purchaser  taking  over  the  physical  properties  at  book  values, 
and  its  effect  is  to  shift  the  burden  of  any  losses  or  omis- 
sions from  the  purchaser  of  the  property  and  assets,  on  to 
the  vendor.  Such  a  transfer  can  not  in  any  way  affect  the 
earning  capacity,  and  it  is  essential  that  any  losses  or  liabili- 
ties omitted  on  account  of  such  guarantees  should  be  taken 
into  account  in  determining  the  profits. 

This  factor  may  be  of  even  greater  importance*  when 
goodwill  is  included  in  the  sale  at  a  price  based  on  a  number 
of  years'  purchase  of  the  average  profits.  In  such  a  case  the 
error  in  the  profits  due  to  the  omission  of  guaranteed  assets 
or  liabilities  may  be  multiplied  many  times  over  in  arriving 
at  the  purchase  money  for  goodwill. 

It  may  also  be  noted  that  a  change  in  the  basis  of  inven- 
tory valuations  at  the  end  of  the  period,  as  compared  with 
the  beginning,  will  not  only  result  in  an  erroneous  statement 
of  earning  capacity,  but  also  will  affect  the  purchase  money 
for  goodwill. 

The  foregoing  remarks  upon  guarantees  by  the  vendor 
are  not  intended  to  imply  that  such  guarantees  are  of  no 
value;  on  the  contrary,  a  guarantee  of  collection  of  face 
value  of  book  debts,  as  well  as  of  the  maximum  amount  of 
liabilities,  should  usually  be  required  whenever  the  pur- 
chaser takes  over  all  current  assets  and  assumes  payment 
of  all  liabilities. 

Estimates  of  Anticipated  Economies 

It  may  be  asked  how  far  an  accountant  is  justified  in 
certifying  to  estimates  of  the  extra  profits  that  may  be  real- 
ized as  a  result  of  economies  in  operation  to  be  effected  by 
the  proposed  new  corporation.     Generally  speaking,  it  may 


224    ACCOUNTING    PRACTICE    AND    PROCEDURE 

be  said  that  any  such  certificate  is  inadvisable  and  may  be 
dangerous.  Promoters  are  always  sanguine;  and  experi- 
ence shows  that  such  estimates  are  seldom  realized  in  prac- 
tice, at  any  rate  for  some  years  to  come.  Extra  expenses 
may  be  entailed  which  more  than  offset  any  savings  effected ; 
and  the  loss  of  personal  touch  and  interest  on  the  part  of  the 
former  owners,  who  now  become  mere  salaried  employees  of 
a  corporation,  may  result  in  less  careful  and  more  extrava- 
gant management.  While  the  vendors  may  be  still  largely 
interested  as  stockholders,  it  may  be  found  that  they  have 
received  cash  payment  for  a  substantial  part  of  their  original 
investment,  and  that  their  remaining  interest  in  the  stock 
represents  merely  goodwill  or  similar  intangible  assets ;  with 
the  result  that  as  salaried  officials  they  may  relax  rather  than 
increase  their  efforts.  Moreover,  the  large  capital  of  the 
modern  consolidation  appears  to  call  for  expenditures  on 
elaborate  offices  and  establishments  which  were  previously 
deemed  entirely  unnecessary,  and  in  fact,  while  the  in- 
creased capital  represents  mainly  goodwill,  etc.,  it  carries 
with  it  an  increased  expenditure  in  hard  cash.  Having  in 
view  all  these  possibilities,  it  is  certainly  not  a  wise  thing 
for  the  accountant  to  certify  to  any  estimate  of  possible 
economies. 

Estimates  of  Future  Earnings 

Accountants  may  be  asked  to  prepare  estimates  of  future 
earnings  for  the  purpose  of  publication  in  the  prospectus, 
and  it  is  well  to  consider  whether  such  a  request  should  or 
should  not  in  general  be  complied  with.  It  may  be 
admitted  that  an  accountant  is  perhaps  in  many  ways  par- 
ticularly qualified  to  prepare  such  an  estimate;  and  if  the 
only  questions  involved  were  the  accuracy  of  the  figures  and 
the  reasonable  probability  that  the  bases  assumed  would 
agree  with  future  practice,  no  objection  perhaps  could  be 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT   225 

taken  to  compliance  with  the  request.  But,  on  the  other 
hand,  the  experience  of  the  past  is  frequently  no  guide  to  the 
practice  of  the  future,  and  many  unforeseen  contingencies 
may  arise  which  will  render  the  estimates  entirely  valueless. 
To  bring  out  the  difficulties  more  clearly,  assume  two  special 
cases : 

Firstly.  That  of  a  factory  which  has  not  been  operating 
to  its  full  capacity,  partly  because  the  plant  is  a  new  one  and 
partly  because  its  selling  organization  is  not  fully  developed. 

Secondly.  That  of  a  new  industry  which  has  been  oper- 
ating in  an  experimental  way  with  one  or  two  machines, 
upon  the  experience  of  which  it  is  desired  to  estimate  the 
profits  that  would  be  earned  in  a  much  larger  plant  con- 
structed on  the  same  principles. 

In  the  first  case  the  actual  operation  of  the  plant  in  the 
past  is  available  as  a  guide  for  the  future,  but  in  preparing 
estimates  of  results  based  on  a  much  more  complete  opera- 
tion, the  following  points  would  have  to  be  carefully 
considered : 

(i)  Are  the  capacities  of  the  different  portions  of  the 
plant  dealing  with  the  various  processes  of  manufacture  so 
carefully  balanced  that  those  dealing  with  the  final  processes 
can  be  worked  to  their  full  capacity  without  overloading 
those  engaged  on  the  earlier  operations? 

(2)  Can  sufficient  supplies  of  raw  material  be  obtained 
at  a  reasonable  cost  to  enable  the  final  output  to  be  largely 
increased  at  not  more  than  the  average  cost  which  has  pre- 
vailed in  the  past? 

(3)  If  the  output  is  so  increased,  can  a  ready  market  be 
found  for  it  at  the  average  prices  obtained  in  the  past?  It 
may  happen  that,  by  reason  of  competition  of  distant  fac- 
tories better  situated  and  with  facilities  which  enable  them 


226    ACCOUNTING    PRACTICE    AND    PROCEDURE 

to  produce  at  lower  cost,  the  territory  in  which  the  products 
of  a  particular  factory  can  be  sold  will  be  restricted  and 
unable  to  absorb  the  increased  production  upon  which  the 
estimates  are  based.  In  such  cases  the  increase  could  only 
be  sold  at  a  considerable  reduction  in  price,  which  would 
entirely  upset  the  estimated  results. 

(4)  For  what  portion  of  each  year  can  the  whole  plant 
be  operated  to  its  full  capacity  ?  And  what  allowance  should 
be  made  for  periods  of  idleness  necessary  to  undertake 
repairs  and  renewals,  periodical  stock-taking,  etc.  ? 

(5)  Where  the  output  depends  upon  the  speed  at  which 
the  machinery  is  run,  can  a  sufficient  supply  of  suitable  labor 
be  obtained  to  run  the  whole  factory  at  the  same  average 
speed  as  it  has  been  possible  to  run  only  a  portion  of  it  in 
the  past  ? 

(6)  What  proportion  would  the  general  management 
and  selling  expenses  bear  to  the  increased  output?  It  may 
happen  that  a  large  concern  can  not  be  run  as  economically 
in  some  departments  as  a  small  one;  and  it  is  not  always  safe 
to  assume  that  the  same  percentage  of  management  and 
selling  expenses  which  prevailed  in  the  past  will  be  experi- 
enced in  the  future. 

(7)  On  the  other  hand,  what  consideration  should  be 
given  to  the  possible  reduction  in  cost  resulting  from  the 
larger  output,  mainly  by  reason  of  the  fuller  use  made  of 
the  facilities? 

It  should  be  clear,  therefore,  from  the  above  considera- 
tions that  any  estimate  of  future  earnings  must  necessarily 
depend  upon  so  many  contingencies  that  it  would  hardly 
seem  desirable  that  it  should  be  put  forth  without  calling 
specific  attention  to  the  assumptions  involved;  and  an  esti- 
mate with  such  qualifications  attached  would  hardly  be  of 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    227 

much  service  to  the  promoter  arid  would  not  be  incorporated 
in  the  prospectus. 

Inasmuch  as  the  community  is  being  educated  to  con- 
sider that  statements  emanating  from  a  pubHc  accountant 
deal  with  facts  only,  it  may  be  said  in  conclusion  that  in  such 
a  case  as  that  supposed,  the  accountant's  duty  should  end 
with  the  submission  on  request  of  a  carefully  prepared  esti- 
mate accompanied  by  all  the  necessary  qualifications,  with- 
out, however,  any  certificate  thereto,  leaving  his  client  to 
print  such  estimate  in  the  prospectus  or  not  as  he  thinks  fit, 
but  without  using  the  name  of  the  accountant. 

The  second  case  is  even  stronger  than  the  first,  for  here 
there  is  no  pretense  that  the  factory  has  been  operated 
commercially  at  all,  the  whole  process  of  manufacture  being 
in  an  experimental  stage.  The  contingencies  involved  in 
assuming  that  the  results  obtained  in  an  experimental  stage 
by  one  or  two  machines  could  be  reached  on  a  much  larger 
scale  in  a  fully  operated  factory,  are  so  many  and  so  unfore- 
seen that  it  would  be  difficult  to  enumerate  them ;  and  under 
these  circumstances,  while  the  accountant  can  for  the  benefit 
of  his  client  check  to  the  best  of  his  ability  any  estimates 
that  may  be  prepared  by  the  manager,  and  may  frequently 
be  able  to  point  out  omissions  therein,  it  is  very  doubtful 
whether  he  should  under  any  circumstances  whatever  attach 
his  signature  to  any  such  statement,  however  much  he  may 
believe  in  the  possibilities  of  its  realization  in  the  future. 

Certificate  of  Financial  Condition 

So  far  attention  has  been  restricted  to  the  essentials  in- 
volved in  certificates  of  profits  for  prospectus  purposes.  It 
remains  to  consider  the  responsibilities  of  the  accountant  in 
giving  certificates  of  financial  condition  for  the  same 
purpose. 


228    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Statements  of  financial  condition  are  usually  in  the  fol- 
lowing form : 

Properties    owned     (showing    basis    of 
valuation)  $ 

Current  Assets : 
Stock  in  Trade 
Accounts  and  Bills  Receivable 
Marketable  Investments 
Cash 
Less: 

Current    Liabilities    consisting    of 
Accounts  Payable 
Net  Current  Assets 


Net  Assets  $ 


If  there  is  any  funded  debt  ranking  in  front  of  the 
securities  to  be  issued,  this  also  would  be  deducted.  The 
fixed  properties  are,  or  should  be,  appraised  by  responsible 
valuers,  frequently  under  the  direction  of  or  assisted  by 
the  accountant,  and  the  certificate  of  these  valuers  would 
usually  be  incorporated  in  the  prospectus,  or  reference  made 
thereto.  The  accountant's  responsibility  is  usually  limited  to 
the  verification  and  certification  of  the  current  assets  and 
liabilities ;  but  questions  may  arise  on  stock  in  trade,  guar- 
antees of  debts  and  liabilities,  contracts  for  purchase  and 
sale  of  goods,  and  orders  in  hand,' which  may  have  an  im- 
portant bearing  on  the  present  and  future  position  and 
should  not  be  overlooked.  For  the  discussion  of  these  ques- 
tions reference  may  be  made  to  page  i86  et  seq. 

Certificate  of  Profits  Without  Certificate  of  Assets 

It  may  and  often  does  happen  that  a  certificate  of  profits 
is  required  without  any  certificate  of  assets,  and,  provided 
that  the  investigation  made  discloses  no  features  in  the 
assets  or  liabilities  which  have  an  important  bearing  upon 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    229 

the  future  of  the  business,  and  should  therefore  be  disclosed 
to  the  prospective  investor,  there  would  appear  to  be  no 
reason  why  such  a  request  should  not  be  complied  with.  At 
the  same  time  there  can  be  little  doubt  that  a  statement  of 
profits  without  assets  is  not  a  complete  one  and  should  be 
looked  upon  with  some  suspicion. 

While  the  accountant  may  be  absolved  from  responsi- 
bility by  his  instructions,  he  is  certainly  bound  by  his  pro- 
fessional duty  to  make  his  examination  so  complete  as  to 
enable  him  to  ascertain  for  himself  what  the  financial  condi- 
tion is,  and  whether  there  is  anything  material  therein  which 
should  be  disclosed.  Such  features  may  be  one  or  more  of 
the  following: 

( 1 )  Accounts  receivable  not  liquid,  but  tied  up  in  loans 

and  not  readily  collectible. 

(2)  Inventories  too  large  for  the  business  carried  on, 

and  including  large  amounts  of  old  or  obsolete 
stock,  or  other  doubtful  items. 

(3)  Marketable  investments  not  really  marketable. 

(4)  Current  liabilities  largely  in  excess  of  current  assets, 

or  with  an  insufficient  margin  for  working  capital 
after  allowing  for  new  capital  to  be  introduced. 

(5)  Large  construction  works  in  progress  calling  for 

continuous  outlay. 

(6)  Funded  debt  falling  due  at  short  future  dates. 

(7)  Insufficiency  of  the  new  money  asked  for  in  the 

prospectus  to  provide  for  these  various  features 
for  at  least  a  reasonable  period  in  the  future. 

It  is  difficult  to  lay  down  any  general  principle  to  cover 
this  point,  but  an  examination  might  reveal  such  a  general 
condition  that  a  true  and  full  disclosure  to  the  pros- 
pective investor  would  not  be  made,  unless  a  statement  of 
assets  and  liabilities,  together  with  the  requirements  in  the 


230   ACCOUNTING    PRACTICE    AND    PROCEDURE 

near  future,  were  made  in  the  prospectus.  If  such  dis- 
closures were  not  made,  it  might  be  the  accountant's  duty 
to  refuse  to  be  connected  with  the  prospectus  in  any  way,  or 
to  certify  even  to  the  statement  of  earnings. 

Liability  of  Certifying  Accountant 

The  question  of  the  personal  liability  of  the  accountant 
for  a  certificate  which  he  gives  to  vendors  or  purchasers, 
and  which  is  published  in  a  prospectus  issued  to  the  public, 
is  a  matter  of  considerable  importance.  The  accountant  is 
not  infallible,  his  judgment  may  be  at  fault,  and  the  available 
information  may  be  incomplete  or  misleading  in  such  a  way 
that  with  all  his  special  skill  the  real  facts  are  not  discover- 
able. It  does  not  follow,  if  future  results  are  not  in  accord- 
ance with  past  experience  to  which  the  accountant  has  certi- 
fied, that  the  latter  is  necessarily  to  blame ;  but  the  public,  to 
whom  he  is  chiefly  responsible,  is  entitled  to  assume  that  he 
is  a  man  skilled  in  commercial  and  financial  affairs,  and  par- 
ticularly in  the  accounts  relating  thereto ;  and  consequently 
actions  or  opinions  on  his  part,  which  could  in  no  way  be 
considered  as  such  in  the  case  of  a  man  without  such  special 
knowledge  and  training,  may  easily  subject  him  to  a  charge 
of  negligence.  He  is  called  upon  to  exercise  the  skill  and 
knowledge  acquired  in  his  profession  to  the  utmost  of  his 
ability;  if  by  negligence  he  fails  in  this,  he  has  committed 
a  breach  of  trust,  has  deceived  the  public,  and  must  be  pre- 
pared to  take  the  consequences.  On  the  other  hand,  no  lia- 
bility should  attach  to  him  for  a  mere  error  of  judgment,  or 
even  for  errors  in  facts  the  existence  of  which  reasonable 
skill  and  diligence  on  his  part  would  not  have  enabled  him  to 
ascertain.  And  finally  the  accountant  should  confine  himself 
to  certifying  to  facts,  and  should  not  attempt  to  deal  with 
estimates  in  .the  making  of  which  his  special  qualifications 
are  no  greater  than  those  of  other  business  men. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    23 1 

(2)  In  Respect  of  Audit 

The  audit  here  referred  to  is  the  annual  review,  by 
persons  entirely  independent  of  the  firm  or  corporation,  of 
its  accounts  and  affairs.  Unfortunately  this  term  "Audit" 
has  obtained  currency  in  a  much  more  limited  sense,  being" 
applied  to  the  internal  check  upon  transactions  involved  in 
the  passing-  of  accounts  for  payment ;  and  the  corresponding 
term  "Auditor"  more  often  than  not  is  applied  to,  or  is  held 
to  describe,  an  individual  holding  the  position  of  comptroller 
or  chief  accountant,  or  head  bookkeeper  of  a  corporation. 
It  is,  perhaps,  worthy  of  consideration  whether  it  is  desir- 
able to  continue  to  use  the  term  "Audit"  as  applied  to  work 
done  and  certificates  given  by  public  accountants;  but  in 
default  of  any  better  term,  and  in  view  of  the  legal  sanction 
given  to  its  use  in  that  respect  in  other  countries,  it  is  very 
generally  adopted  as  applying  to  the  work  performed  by  the 
independent  auditor,  to  enable  him  to  certify  to  the  accuracy 
of  periodical  statements  of  account.  Such  an  audit  is  of 
far-reaching  importance,  not  only  to  the  directors  and  stock- 
holders of  the  corporation  interested,  but  also  to  the  general 
public,  who  may  frequently  purchase  the  stock  of  the  cor- 
poration, relying  on  the  certificate  given  by  the  public 
accountant. 

Audit  Practice  in  England 

Some  important  considerations  affecting  audit  practice 
are  suggested  by  the  English  Companies  (Consolidation) 
Act  of  1908,  which  was  passed  after  an  inquiry  by  a  Royal 
Commission  on  which  accountants  were  represented  by  one 
of  their  number,  and  which  may  be  said  to  have  crystallized 
into  law  the  customs  of  the  most  reputable  companies, 
adopted  as  the  result  of  the  forty-five  years'  experience  under 
the  law  of  limited  liability  in  that  country.  Before  consider- 
ing the  provisions  of  this  act  it  may  be  interesting  and  useful 


22^2.    ACCOUNTING    PRACTICE    AND    PROCEDURE 

here  to  state  shortly  the  history  of  the  independent  and 
impartial  audit  of  the  accounts  of  corporations  in  England, 
where  the  practice,  starting  from  small  beginnings,  has  now 
become  universal  and  has  at  last  received  the  indorsement  of 
the  law. 

Until  the  passage  in  England  of  the  Companies  Act  of 
1900,  there  was  no  law  compelling  a  company  registered 
under  the  Companies  Act  to  have  an  audit  of  its  accounts, 
with  the  exception  of  banking  companies,  which  were  re- 
quired under  the  Companies  Act  of  1879  to  have  an  inde- 
pendent audit,  evidenced  by  a  certificate  in  a  form  which 
practically  became  the  standard  for  all  companies.  The 
original  Limited  Liability  or  Joint-Stock  Companies  Act  of 
1862  contained  in  a  schedule,  known  as  Table  "A,"  a  set 
of  "Articles  of  Association"  (here  known  as  "By-Laws"), 
which  was  not  compulsory,  but  which  could  be  adopted  by 
any  company  so  desiring  and  was  binding  upon  any  com- 
pany which  did  not  adopt  an  alternative  set.  This  Table 
"A"  exercised  a  great  influence,  and  where  not  adopted  in  its 
entirety,  became  the  model  for  the  articles  of  association 
of  the  best  companies.  It  included  a  clause  requiring  an 
annual  audit  of  accounts  by  persons  appointed  by  stock- 
holders ;  and  the  elimination  of  this  clause  in  any  substituted 
articles  came  to  be  regarded  with  more  and  more  disfavor, 
so  that  in  time  this  provision  became  practically  universal. 

The  first  stage  of  this  audit  consisted  in  the  appointment 
by  the  stockholders,  at  the  annual  meeting,  of  certain  of 
their  number  to  conduct  it.  These  lay  auditors  had  no 
qualifications  for  the  position,  either  by  training  or  expe- 
rience; and  while  the  fees  paid  them  for  their  services  were 
usually  small,  there  can  be  little  doubt  that  the  money  was, 
as  a  rule,  wasted. 

The  next  stage  appears  to  have  been  the  employment  by 
the  elected  auditors  of  public  accountants  to  assist  them  in 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    233 

their  work,  provision  being  frequently  found  in  the  articles 
of  association  permitting  this,  and  providing  that  the  re- 
muneration of  the  individuals  so  employed  should  be  paid  by 
the  company.  The  next  step  was  to  recognize  the  fact  that 
it  was  better  for  the  stockholders  themselves  to  make  the 
appointment  of  public  accountants,  instead  of  delegating  it 
to  their  own  auditing  committee;  and  the  articles  of  asso- 
ciation in  their  most  modern  form  usually  provided  that  at 
least  one  of  the  auditors  should  be  a  public  accountant.  In 
this  condition  matters  continued  until  the  passage  of  the 
Companies  Act  of  1900,  which,  for  the  first  time,  gave 
parliamentary  sanction  to  the  practice  which  had  already 
become  established  in  the  majority  of  cases  by  the  action  of 
corporations  and  their  stockholders. 

The  various  Acts  from  1862  up  to  1907  are  now  con- 
solidated in  the  Companies  (Consolidation)  Act,  1908,  and 
the  provisions  relating  to  audit  are  contained  in  Sections  109 
to  114  of  that  Act.*  The  general  effect  of  these  provisions 
is  that  at  each  annual  meeting  of  the  company  the  share- 
holders are  required  to  appoint  one  or  more  auditors,  none 
of  whom  must  be  a  director  or  officer  of  the  company ;  that 
these  auditors  shall  hold  office  until  the  next  annual  meeting, 
and  that  their  remuneration  shall  be  fixed  by  the  share- 
holders. Provision  is  made  for  appointment  by  the  Board 
of  Trade  (a  government  department)  in  default  of  any 
appointment  by  shareholders.  Appointment  by  the  directors 
is  permitted  only  in  the  case  of  a  newly  organized  company ; 
and  such  appointees  can  hold  office  until  the  first  annual 
meeting,  with  power,  however,  to  the  shareholders  to  remove 
them  by  a  majority  vote  at  a  previous  general  meeting. 

The  auditor  being  appointed  by  the  stockholders,  his 
responsibility  was  entirely  to  the  stockholders ;  but  he  was 
subject  to  election  each  year;  and  cases  frequently  arose  in 

*See  Appendix  I. 


234   ACCOUNTING    PRACTICE    AND    PROCEDURE 

which,  owing  to  his  making  a  report  adverse  to  some  action 
which  the  directors  had  taken,  the  latter,  controlHng  the 
majority  of  stock,  were  able  to  prevent  his  re-election.  This 
feature  of  the  appointment  of  auditors  was  recognized  as  a 
defect,  and  the  form  of  certificate  called  for  in  Section  23 
of  the  Act  of  1900  was  also  not  entirely  satisfactory;  the 
Act  of  1908  contains  provisions  safeguarding  the  re-election 
of  auditors  and  amending  the  form'of  certificate. 

The  present  law  establishes  the  auditor's  right  of  access 
at  all  times  to  the  books,  accounts  and  vouchers  of  the  com- 
pany, and  empowers  him  to  require  from  the  directors  and 
officers  such  information  and  explanations  as  he  may  think 
necessary.  It  requires  the  auditor  to  make  a  report  to  the 
shareholders,  stating  whether  or  no  he  has  obtained  all  such 
information  and  explanations,  and  whether  or  no  the  bal- 
ance sheet  is  properly  drawn  up  so  as  to  exhibit  a  true  and 
correct  view  of  the  state  of  the  company's  affairs,  according 
to  the  best  of  his  information  and  the  explanations  given  to 
him,  and  as  shown  by  the  books  of  the  company. 

The  auditor's  report  must  be  read  at  the  annual  meeting, 
and  be  open  to  the  inspection  of  any  shareholder,  who  is 
also  entitled  to  a  copy  of  both  balance  sheet  and  report  for  a 
specified  fee. 

The  act  also  provides  that  no  other  than  a  retiring  auditor 
can  be  elected  at  an  annual  meeting,  unless  previous  notice 
has  been  given  of  the  intention  to  nominate  another  person, 
and  a  copy  of  such  notice  has  been  given  to  the  retiring 
auditor. 

It  will  be  noted  that  there  is  still  no  provision  in  the  law 
requiring  that  the  audit  should  be  made  by  a  public  account- 
ant, but  it  has  become  so  universally  recognized  that  a  lay 
audit  is  worse  than  useless,  that  it  is  now  quite  the  exception 
to  find  the  certificate  of  any  but  a  public  accountant  affixed 
to  the  balance  sheet. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    235 

American  and  English  Practice  as  to  Company  Audits 

There  is  one  important  point  of  distinction  between 
the  position  of  the  public  accountant  acting  as  auditor  of  a 
corporation  in  England  and  in  this  country;  viz.,  that  in 
England  he  has  always  been  appointed  by  the  shareholders, 
while  in  America,  at  present,  with  a  few  notable  exceptions, 
he  is  appointed  by  the  directors  or  officers,  although  in  most 
cases  the  directors  hold  the  control  of  the  company,  and  the 
appointment  by  the  stockholders  would  practically  have  the 
same. result.  The  accountant's  position  in  such  a  case  is, 
however,  widely  different.  When  appointed  by  the  directors 
his  legal  responsibility  is  to  them,  not — as  it  should  be — to 
the  stockholders  and  to  the  public ;  and  while  this  should  not 
affect  his  moral  responsibility  to  the  two  latter,  it  places  such 
limitation  upon  his  powers  as  to  seriously  diminish  his  use- 
fulness; for  if  he  reports  adversely  upon  any  of  the  actions 
of  the  directors,  they  can  suppress  his  report  and  publish  the 
accounts  of  the  company  as  prepared  by  themselves  without 
any  certificate;  and  the  auditor  has  no  right  whatever  to 
communicate  the  true  facts  to  tlijs  stockholders.  On  the 
other  hand,  if  he  be  appointed  by  the  stockholders,  it  is  not 
only  his  right  but  his  duty  to  bring  before  them — preferably 
in  his  certificate  ajffixed  to  the  balance  sheet,  but  certainly 
in  some  way — any  material  facts  with  which  they  should  be 
acquainted.  Furthermore,  if  the  directors  appoint  the 
auditor  they  can  limit  the  scope  of  his  inquiry  in  any  way 
they  think  fit ;  while  appointment  by  the  stockholders  would 
carry  with  it  no  limitations,  and  the  whole  responsibility  as 
to  the  work  which  he  shall  do  or  not  do  is  thrown — and 
properly  thrown — upon  the  auditor. 

Canadian  Audit  Practice 

Reference  may  here  be  made  to  the  Canadian  Bank  Act 
of  1913,  which  for  the  first  time  in  the  experience  of  Canada, 


236    ACCOUNTING    PRACTICE    AND    PROCEDURE 

provides  for  the  compulsory  audit  of  the  accounts  of  all 
Canadian  banks  by  persons  appointed  by  the  shareholders. 
The  clauses  of  the  Act  dealing  with  this  audit*  provide  that 
the  bank  managers  shall  select  a  list  of  not  less  than  forty 
names  of  persons  qualified  to  make  such  an  audit.  This  list 
so  prepared  is  submitted  to  and  approved  by  the  Minister 
of  Finance;  and  thereafter  the  shareholders  at  the  annual 
meeting  of  each  bank  are  required  to  appoint  as  auditor  one 
of  the  persons  included  in  such  list.  Very  wide  powers  are 
given  to  the  auditor  in  the  Act ;  his  duties  are  clearly  defined 
and  his  responsibilities  are  undoubtedly  considerable. 

Accountant's  Responsibility  for  Audit  Certificates 

The  responsibility  which  the  public  accountant  assumes 
in  certifying  to  the  accounts  of  a  corporation  is  well  defined 
in  the  form  of  certificate  required  by  the  English  Companies 
Act  of  1908,  above  quoted ;  viz.,  that  he  shall  report  whether, 
in  his  opinion,  the  balance  sheet  is  properly  drawn  up  so  as 
to  exhibit  a  true  and  correct  view  of  the  state  of  the  com- 
pany's affairs,  according  to  the  best  of  his  information  and 
the  explanations  given  him,  and  as  shown  by  the  books  of 
the  company.  The  several  phrases  in  this  certificate  deserve 
special  attention. 

(a)  "In  his  opinion,"  •  as  a  skilled  professional  man, 
endowed  with  special  qualifications  resulting  from  his  train- 
ing and  experience.  Every  balance  sheet  must  be  largely  a 
matter  of  opinion ;  for  example :  the  value  of  the  debts 
receivable,  the  inventories  of  materials  and  supplies,  and 
particularly  of  work  in  progress,  and  the  division  of  expendi- 
tures between  capital  and  revenue ;  the  inclusion  in  the  books 
of  all  necessary  information  with  regard  to  the  affairs  of 
the  company ;  the  sufficiency  of  the  provision  made  for  main- 
tenance charges  and  depreciation,  and  for  reserves  for  possi- 


•See  Appendix  V. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    237 

ble  losses ;  the  efficiency  of  the  system  of  organization  and 
accounting  as  a  reasonable  protection  against  fraud  or 
defalcation — all  of  these  matters  require,  for  their  decision, 
skill  and  experience. 

The  criticism  is  often  made  that  this  phrase  weakens  the 
certificate;  but  if  the  necessities  of  the  case  be  considered, 
and  if  it  be  remembered  that  the  opinion  is  one  formed  after 
an  exhaustive  and  careful  study  of  all  the  facts  and  evidence 
obtainable  by  a  man  whose  whole  training  and  experience 
has  specially  qualified  him  to  give  such  an  opinion,  it  will 
be  seen  that  the  words  are  not  a  mere  empty  phrase  but  an 
essential  part  of  the  certificate.  So  far  from  weakening  the 
certificate,  they  may  rather  be  considered  as  strengthening  it, 
in  that  they  imply  that  the  signer  has  given  his  certificate, 
not  with  foolhardy  assurance,  but  with  a  realization  of  the 
inherent  impossibility  of  saying,  absolutely,  that  one  balance 
sheet  is  correct  and  any  other  incorrect. 

(b)  "Properly  drawn  up."  This  implies  that  the  differ- 
ent headings  in  the  accounts  submitted  are  proper  descrip- 
tions of  the  items  included  thereunder:  that  there  is  no 
concealment  of  material  facts,  the  knowledge  of  which  is 
essential  in  enabling  the  present  or  prospective  stockholders 
to  form  a  judgment  of  the  value  of  the  investment,  and  the 
omission  of  which-  would  be  prejudicial  to  their  interests. 
In  deciding  whether  this  requirement  has  been  met,  the 
auditor  must  recognize  that  there  are  often  facts  as  to  which 
it  would  be  of  interest  and  value  to  stockholders  to  be 
informed,  but  the  public  disclosure  of  which  might  damage 
the  company  and  its  stockholders,  and  yet  which,  in  the 
opinion  of  the  public  accountant,  are  perfectly  proper  trans- 
actions, and  in  the  best  interests  of  the  company.  The  public 
accountant  should  be  the  best  judge  as  to  what  should  or 
should  not  be  disclosed,  and  be  able  to  satisfy  his  clients  that 
his  views  are  correct  and  should  be  adopted. 


238    ACCOUNTING    PRACTICE    AND    PROCEDURE 

(c)  "True  and  correct  view  of  the  state  of  the  com- 
pany's affairs."  This  phrase  involves,  not  only  the  clerical 
accuracy  of  the  figures,  but  their  substantial  business 
accuracy,  independently  of  the  books,  subject  always  to  the 
necessary  qualification  that  the  public  accountant,  even  with 
his  special  training  and  experience,  is,  after  all,  human  and 
can  not  discover  facts  of  which  no  trace  is  to  be  found  on 
the  books  or  records  of  which  he  has  knowledge.  Such 
matters  as  the  valuation  of  inventories,  investments,  book 
debts,  etc. ;  the  full  estimate  of  all  ascertainable  liabilities  and 
obligations,  contingent  or  otherwise;  the  full  and  correct 
statement  of  the  profits  for  the  period  covered  by  the  exami- 
nation; and  the  clear  and  separate  disclosure  therein  of  any 
unusual  items  not  incident  to  the  ordinary  business  of  the 
company,  are  all  involved  in  the  term  "true  and  correct  view 
of  the  state  of  the  company's  affairs." 

(d)  "As  shown  by  the  books  of  the  company."  This 
phrase  does  not  imply  that  the  duties  of  the  auditor  are 
properly  fulfilled  if  he  satisfies  himself  that  the  balance  sheet 
agrees  with  the  books,  as  is  sometimes  supposed.  The  pre- 
ceding phrase,  "according  to  the  best  of  my  information  and 
the  explanations  given  to  me,"  shows  clearly  that  a  much 
wider  duty  rests  upon  the  auditor ;  namely,  to  satisfy  himself 
that  the  balance  sheet,  as  already  stated,  sets  forth  a  true 
and  correct  view  of  the  state  of  the  company's  affairs, 
according  to  all  the  information  obtainable;  and,  further, 
that  the  books  also  set  forth  this  same  condition.  It  is,  there- 
fore, incumbent  upon  the  auditor,  if  he  certifies  the  accounts 
of  a  company,  to  see  that  the  books  are  correct  as  well  as 
the  balance  sheet,  and  that  any  changes  which  he  may  have 
to  make  in  the  balance  sheet  have  been  properly  recorded 
and  put  through  the  books. 

There  are  many  other  matters  frequently  touched  upon 
in  the  certificate,  in  addition  to  the  above,  which  may  be 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    239 

described  as  the  "Operative"  phrases ;  but  whatever  the  form 
may  be,  it  is  essential  that  the  certificate  should  be  clear, 
specific,  and,  above  all,  accurate,  and  that  any  qualifications 
which  it  may  be  necessary  to  insert  should  be  set  forth  in 
unmistakable  terms,  so  as  to  put  those  who  read  it  upon 
their  guard,  and  to  suggest  to  them  the  questions  which 
shall  be  put  to  the  management  of  the  corporation  if  further 
information  is  desired. 

Qualified  Certificates 

It  may  be  useful  here  to  state  a  few  general  principles  in 
connection  with  the  form  a  qualification  should  take. 
Various  expressions  are  used,  such  as  "accepting"  or  "sub- 
ject to"  such  a  condition  of  things.  The  former  word 
should  imply  that,  while  the  accountant  is  not  in  a  position 
to  verify  the  statement  to  which  it  relates,  yet  he  has  no 
reason  to  believe  that  it  is  inaccurate  in  any  respect;  while 
the  expression  "subject  to"  should  imply  that  the  accountant 
is  not  satisfied  with  the  conditions  disclosed,  and  is  prepared 
only  to  certify  to  the  accuracy  of  the  statement,  excluding 
the  item  to  which  he  takes  exception. 

It  must  never  be  forgotten  that  the  auditor  has  no  right 
or  duty  to  dictate  the  policy  of  the  company;  he  can  not 
compel  it  to  make  sufficient  provision  for  all  necessary 
charges,  such  as  maintenance,  depreciation,  bad  debt  re- 
serves, etc.,  but  he  can  and  must  call  attention  in  his  certifi- 
cate to  the  fact  of  the  omission  or  insufficiency  of  any  such 
provisions,  leaving  it  to  those  interested  as  stockholders,  or 
in  any  other  capacity,  to  take  the  question  up  directly  with 
the  officials  and  satisfy  themselves  on  these  doubtful  points. 
If  the  public  accountant  is  equipped  by  ability  and  training 
for  his  duties;  if  the  work  of  his  subordinates  is  properly 
directed  and  supervised ;  and  if  his  examination  has  been  as 
thorough  as  it  should  have  been — in  other  words,  if  he  has 


240    ACCOUNTING    PRACTICE    AND    PROCEDURE 

done  his  whole  duty  as  a  public  accountant — it  is  hardly 
possible,  in  the  absence  of  widespread  fraud,  for  any  sub- 
stantial or  material  errors  of  omission  or  commission  to  be 
found  afterwards  in  a  balance  sheet  so  certified. 

Accountant's  Moral  and  Legal  Responsibility 

The  public  accountant's  responsibility  in  respect  of  his 
certificates  is  largely  moral,  and  only  to  a  small  extent  legal. 
It  is  commonly  supposed  that  his  work  is  a  mere  ascertain- 
ment of  facts,  and  yet  that  is  the  simplest  and  frequently  the 
smallest  and  least  important  part  of  the  work  involved  in  his 
periodical  examinations.  He  is  rather  employing  his  trained 
mind  and  organization  to  make  as  near  an  approximation  to 
actual  facts  as  is  practicable,  but  he  has  also  to  consider 
degrees  of  approximation ;  or,  in  other  words,  it  is  the  per- 
centage, and  not  the  amount  of  the  possible  error,  by  which 
he  must  be  guided.  His  legal  responsibility  is  necessarily 
limited  to  gross  errors  of  omission  or  commission,  and 
would  not  extend  to  errors  of  judgment;  but  it  must  be 
remembered  that  what  might  be  merely  errors  of  judgment 
on  the  part  of  an  individual  without  his  training  and  expe- 
rience, may  easily  be  gross  errors  on  the  part  of  the  public 
accountant. 

(3)  In  Respect  of  Liquidation  and  Reconstruction 

The  duties  of  the  public  accountant  in  respect  of  liquida- 
tion and  reconstruction  have  in  this  country  in  the  past  been 
largely  confined  to  reporting  on  the  condition  of  an  insol- 
vent concern,  and  on  the  past  results,  in  so  far  as  these  are 
not  already  known,  which  have  contributed  to  the  present 
condition.  In  some  few  cases  an  accountant  has  been 
appointed  receiver  or  manager  of  an  insolvent  business ;  but 
this,  while  an  important,  is  not  a  large  part  of  his  duties 
here,  as  it  has  been  for  many  years  in  Great  Britain.    The 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    24I 

problems  involved  in  such  duties  of  management  hardly 
have  relation  to  accounts,  and  their  discussion  has  no  place 
here  except  perhaps  to  note  that  a  thorough  knowledge  of 
accounts  and  the  principles  upon  which  they  should  be  pre- 
pared is  of  the  utmost  value  in  their  consideration  and 
settlement. 

The  forms  of  reports  necessary  do  not  materially  differ 
from  those  already  discussed,  and  the  principles  involved  are 
the  same.  There  is,  however,  this  important  difference  that, 
in  the  case  of  liquidation  followed  by  a  break-up  sale,  the 
values  to  be  placed  upon  the  assets  will  be  no  longer  going 
values,  but  forced  sale  values.  Under  these  conditions 
finished  products  on  hand  will  bring  much  less  than  normal 
selling  price,  partly  finished  products  may  be  almost  value- 
less, while  raw  materials  may  have  a  value  fairly  close  to 
their  cost.  Accounts  and  bills  receivable,  which  for  a  going 
concern  may  be  doubtful  of  collection,  will  possibly  be  found 
altogether  bad ;  while  all  the  varied  items  of  deferred  charges 
and  other  working  assets  will  have  little  or  no  value.  The 
values  of  capital  assets  under  such  conditions  will  in  many 
cases  shrink  to  a  mere  fraction  of  their  book  values,  and  even 
then  may  be  unsaleable  for  a  long  period.  With  all  this 
shrinkage  in  asset  values  the  liabilities  remain  the  same,  and 
consequently  concerns  which  might  quite  properly  have 
shown  some  surplus  of  assets  over  liabilities  as  long  as  the 
business  was  continuing,  will  show  a  large  and,  to  those 
most  interested  as  owners  or  stockholders,  a  surprising 
deficit. 

Responsibility  of  Accountant  in  Case  of  Business  Failure 

In  view  of  the  serious  losses  thus  entailed,  the  public 
accountant,  who  may  have  been  in  close  touch  with  the  busi- 
ness for  a  long  period  before  its  collapse,  incurs  a  heavy 
responsibility.     His  trained  eye  should  be  able  to  discover 


242    ACCOUNTING    PRACTICE    AND    PROCEDURE 

the  tendency  to  failure,  and  often  to  suggest  means  for  avert- 
ing the  impending  catastrophe.  The  most  difficult  matter 
for  his  judgment  is  to  decide  at  what  point  it  is  his  duty 
to  creditors,  stockholders  and  the  public,  to  make  such  refer- 
ences in  his  public  reports  as  will  necessarily  bring  an  end 
to  the  suspense.  As  long  as  there  is  a  reasonable  prospect 
of  a  rehabilitation  without  recourse  to  the  drastic  remedy  of 
liquidation,  with  all  the  losses  it  entails,  it  would  seem  to  be 
his  duty  to  all  concerned  to  refrain  from  any  acts  which 
would  bring  it  about;  but  his  judgment  must  be  based  on 
facts  and  probabilities,  and  not  on  mere  hopes  or  possibili- 
ties such  as  will  naturally  govern  the  actions  and  decisions 
of  the  managers  and  partners  or  stockholders,  A  stoppage 
at  an  early  stage,  while  it  will  naturally  appear  a  hardship 
and  will  bring  loss  to  all  concerned,  may  easily  prevent  a 
much  worse  state  of  things,  and  lead  to  an  early  reorganiza- 
tion, which  may  well  be  much  less  unfavorable  to  all  than  if 
the  business  were  continued  unchecked  to  a  later  date.  The 
realization  of  the  existence  of  germs  of  insolvency  at  the 
earliest  possible  date  is  a  matter  of  considerable  diffiiculty. 

Causes  or  Conditions  Leading  Up  to  Insolvency 

The  most  usual  of  these  may  be  summarized  thus : 
( I )  Continuous  losses  in  operations  leading  to  a  shrink- 
age in  available  current  assets  and  loss  of  credit.  These 
losses  may  be  due  either  to  want  of  a  sufficient  amount  of 
business  at  profitable  prices;  to  bad  workmanship;  to  in- 
ability— owing  to  inferior  management  and  high  costs — to 
meet  competition,  or  to  extensions  of  plant  to  an  amount 
largely  in  excess  of  the  probable  demand  for  product.  Such 
causes,  if  found  out  in  time,  can  mostly  be  remedied;  but 
frequently  the  exact  cause  of  losses  is  unknown,  by  reason 
of  the  absence  of  any  reliable  cost  accounts  which  would  dis- 
close weak  points  and  enable  economies  to  be  effected. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    243 

As  long  as  working  capital  is  ample  such  losses  may  be 
continued  for  a  long  time  without  disaster,  and  frequently 
it  happens  that  continued  hopes  of  improvement  in  general 
trade,  to  which  alone  such  losses  are  frequently  attributed, 
lead  to  an  almost  reckless  continuance  of  business  without 
any  attempt  to  detect  the  internal  evils  which  may  be  the 
real  cause.  When  working  capital  is  exhausted  the  same 
optimistic  views  lead  to  borrowing  for  working  capital,  with 
the  only  result  of  a  worse  final  disaster. 

(2)  Excessive  borrowing  on  temporary  loans  to  pro- 
vide for  additional  permanent  assets  or  even  for  working 
capital.  In  times  of  financial  stringency  loans  may  be  called 
in,  and  even  a-  concern  with  a  moderately  good  business  and 
excellent  prospects  of  future  increase,  may  find  itself  sud- 
denly thrown  into  insolvency  for  want  of  sufficient  liquid 
assets.  This  is  a  frequent  source  of  insolvency,  owing  to  the 
fact  that  temporary  loans  can  be  negotiated  in  good  times; 
and  even  in  moderately  bad  times  they  can  be  negotiated 
more  easily  than  permanent  loans.  Generally  it  may  be  said 
that  loans  for  short  terms  for  the  purpose  of  permanent  im- 
provements and  extensions  of  a  business  are  a  source  of 
danger  at  any  time,  and  should  be  considered  as  one  of  the 
most  fruitful  seeds  of  insolvency. 

(3)  The  expenditures  out  of  current  assets  of  consider- 
able sums  on  capital  account,  thus  diminishing  the  former 
unduly,  in  the  expectation  of  borrowing  money  or  raising 
capital  in  other  ways  which,  owing  to  general  conditions  in 
the  money  market,  may  be  found  impossible  at  the  time 
the  money  is  needed. 

(4)  Large  increases  in  stocks  on  hand  or  accounts  re- 
ceivable out  of  proportion  to  the  total  business  done,  should 
call  for  careful  inquiry.  The  reasons  may  be  quite  sound 
and  the  increase  due  to  temporary  causes,  but  any  continuous 


244    ACCOUNTING    PRACTICE    AND    PROCEDURE 

increase  year  after  year  in  such  items,  accompanied  as  it 
must  usually  be  by  a  corresponding  increase  in  current  lia- 
bilities, or  floating  debt,  is  ground  for  anxiety.  It  points  in 
the  case  of  stock  either  to  accumulation  of  obsolete  or  un- 
suitable goods,  or  to  a  continuous  rise  in  prices  of  material 
and  labor  costs,  or  to  bad  management,  and  in  extreme  cases 
to  deliberate  fraud  in  overstating  either  quantities  or 
prices.  In  the  case  of  accounts  receivable  it  may  be  due  to 
attempts  to  increase  business  by  dealing  with  less  solvent 
customers,  with  consequent  liability  to  heavier  losses  in  bad 
debts;  to  the  financing  of  customers  or  others  who  are  not 
strong  enough  for  the  business  they  are  doing,  or  to  forcing 
goods  onto  the  market  in  times  of  commercial  depression  to 
an  extent  beyond  the  power  of  the  market  to  absorb. 

(5)  The  payment  of  dividends  to  stockholders,  or  dis- 
tribution of  profits  to  proprietors  in  excess  of  current  earn- 
ings. This  may  amount  to  payment  of  dividends  out  of 
capital  (which  is  illegal),  when  the  result  is  an  actual  deficit 
on  the  Profit  and  Loss  account.  In  the  majority  of  cases, 
however,  the  dividends  will  be  paid  out  of  an  accumulated 
surplus  appearing  on  the  face  of  the  accounts.  This  surplus 
may  be  fictitious ;  i.  e.,  it  may  exist  solely  by  reason  of  the 
overvaluation  of  capital  or  current  assets,  or  the  understate- 
ment of  liabilities ;  or  it  may  be  a  real  surplus  which  has 
been  already  used  for  the  extension  of  the  business  and 
which  is  not  therefore  available  in  a  liquid  form  for  any 
purpose.  This  would  be  disclosed  at  any  time  by  a  careful 
scrutiny  of  the  asset  and  liability  values  and  their  composi- 
tion; but  may  not  be  at  all  obvious  to  directors  or  stock- 
holders without  the  aid  of  an  adviser  skilled  in  such  matters, 
who  would  be  able  to  indicate  points  of  weakness.  In  the 
absence  of  deliberate  bad  faith  or  fraud  on  the  part  of 
directors  and  managers,  the  indications  of  possible  danger 
here  stated  are  usually  ignored,  owing  to  excess  of  optimism. 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    245 

or  unwillingness  to  admit  failure,  and  it  is  at  this  point  and 
in  the  early  stages  that  the  public  accountant  can  best  exer- 
cise his  functions,  and,  by  advice  based  on  neither  optimism 
nor  pessimism,  but  on  a  fair  and  impartial  appreciation  of  all 
the  facts,  suggest  a  halt  and  propose  remedies  before  it  is 
too  late.  Neglect  of  such  precautions  will  frequently  lead 
from  mere  optimism  to  a  refusal  to  see  and  recognize  bad 
factors,  and  even  to  crime  in  order  to  conceal  them. 

Reorganization 

Bearing  in  mind  the  heavy  losses  which  must  result  from 
liquidation  and  forced  sale,  it  is  most  desirable  that,  if 
liquidation  comes,  it  should  be  followed  as  speedily  as  possi- 
ble by  an  honest,  conservative  and  successful  reconstruction. 
When  this  can  be  carried  through  without  any  stoppage  of 
operations,  the  greater  part  of  the  heavy  losses  which  must 
result  from  a  forced  collection  of  current  assets  and  sale  of 
capital  assets,  is  avoided,  and  both  creditors  and  stockholders 
largely  benefit. 

The  consideration  of  a  plan  for  the  reorganization  of  a 
property  which  has  been  reduced  to  a  condition  of  insolvency, 
requires  a  full  and  accurate  knowledge  of  all  the  existing 
conditions  with  regard  to  the  property  and  its  past  and 
probable  future  earning  capacity.  The  elements  to  be  inves- 
tigated and  determined  will  therefore  be  as  follows : 

(i)  The  sources  and  nature  of  the  gross  earnings,  and 
the  prospects  of  any  increases  therein  without  further  ex- 
penditures for  development. 

(2)  The  cost  of  operation,  with  particular  reference  to 
the  effect  thereon  of  bad  management  or  bad  organization, 
and  to  the  possibility  of  remedying  these  conditions ;  and  the 
proportion  which  the  cost  of  operation  has  borne  and  may 
be  expected  to  bear  to  the  gross  earnings. 


246    ACCOUNTING    PRACTICE    AND    PROCEDURE 

(3)  A  comparison  of  the  gross  and  net  earnings  and 
capitalization  of  the'  property  with  some  actual  or  desirable 
standard,  so  as  to  determine  the  proportion  which  one  should 
bear  to  the  other  if  the  reorganization  is  to  prove  successful. 

(4)  Hence,  to  arrive  at  the  total  interest-bearing  and 
dividend-paying  capital  which  the  reorganized  property  will 
stand  on  some  fixed  interest  basis. 

(5)  The  rank  of  the  different  classes  of  obligations, 
having  regard  to  the  property  pledged  as  security  therefor ; 
the  margin  of  security;  the  rate  of  interest;  the  date  of 
maturity;  the  equivalent  par  value  on  the  basis  of  the 
standard  rate  of  interest  adopted  for  all  classes;  and,  if 
practicable,  the  extent  to  which  the  properties  specifically 
mortgaged  show  sufficient  earnings  to  meet  interest  on  the 
indebtedness  secured  thereon.  This  class  of  information  will 
probably  require  a  report  from  an  engineer  or  other  expert 
on  the  value  and  the  condition  of  the  physical  property. 

(6)  Following  upon  the  determination  of  these  factors, 
a  consideration  of  the  various  separately-mortgaged  divi- 
sions of  the  property,  with  a  view  to  determining  whether 
any  should  be  abandoned  to  the  bondholders,  rather  than  be 
included  in  a  reorganization ;  and  here  it  is  important  to 
observe  that  the  contribution  of  any  specific  piece  of  property 
to  the  general  organization  is  not  necessarily  measured  by 
its  ability  by  itself  to  earn  interest  on  the  obligations  secured 
thereon.  Numerous  other  factors  will  enter  into  a  considera- 
tion of  this  point,  and  it  may  easily  appear  that  a  property 
earning  little  or  nothing  towards  payment  of  its  obligations 
is  sufficiently  valuable  to  the  organization,  as  a  whole,  to  be 
retained  if  possible. 

(7)  Another  important  factor  is  the  amount  of  new 
money  required  to  be  introduced  for  the  purpose  of  paying 
off  the  floating  debt  and  rehabilitating  the  property,  and  the 


RESPONSIBILITIES  OF  PUBLIC  ACCOUNTANT    247 

best  method  of  raising  such  money — whether  by  the  issue  of 
new  prior  lien  securities  ranking  in  front  of  or  on  an  equality 
with  those  issued  in  exchange  for  existing  mortgages,  or  by 
assessments  on  junior  classes  of  securities.  In  the  latter  case 
it  is  important  that  sufficient  inducement  be  given  to  the 
junior  classes,  in  the  proportion  of  new  securities  issued  for 
old,  to  induce  them  to  pay  these  assessments ;  while  for  the 
assessments  themselves,  the  securities  issued  should  represent 
the  par  value  of  the  cash  paid  in  on  some  reasonable  market 
valuation. 

Upon  the  information  and  facts  so  ascertained  will 
depend  the  final  allocation  to  be  made  of  new  securities  in 
exchange  for  old,  as  far  as  possible,  in  equitable  proportions 
to  the  different  classes  of  security  holders,  although  at  this 
final  stage  an  element  of  bargain  must  necessarily  be  intro- 
duced by  reason  of  the  different  interests  involved  and  the 
necessity  of  the  reorganization  managers  coming  to  terms, 
separately,  with  each  class  of  holders. 

After  this  stage  has  been  reached  there  will  still  remain 
the  work  of  vesting  the  properties  of  the  old  concern  in  the 
new  one,  with  probably  a  reduced  capitalization,  and  usually 
involving  an  adjustment  of  asset  values  on  the  basis  of 
appraisals. 

There  may  be  many  important  questions  arising  in  this 
connection,  not  least  among  which  may  be  the  installation 
of  such  a  system  of  cost  and  general  accounting  as  will 
enable  errors  of  the  past  to  be  avoided  and  put  the  manage- 
ment in  a  position  to  retrieve  the  situation  and  convert  a 
failure  into  success. 

A  company  reorganized  on  such  a  basis  and  placed  under 
capable  management  should  usually  be  successful,  provided 
that  all  the  facts  outlined  above  are  ascertained  by  reputable 
and  responsible  accountants  and  engineers,  and  provided 
that  regard  be  had,  subject  to  the  rights  of  creditors,  solely 


248    ACCOUNTING    PRACTICE    AND    PROCEDURE 

to  the  interests  of  the  company,  as  represented  by  its  stock- 
holders, instead  of  to  those  of  outside  parties  who  may  be 
merely  seeking  to  obtain  as  much  as  possible  for  themselves 
out  of  the  wreck. 

In  reorganizations  in  the  past  this  latter  condition  has 
sometimes  prevailed  with  the  result  that  the  reorganized 
property  has  shown  little  better  results  than  its  wrecked 
predecessor. 


CONCLUSION 

In  concluding  this  review  of  accounting  practice  and 
procedure,  and  the  duties  and  responsibilities  of  the  public 
accountant  in  relation  thereto,  it  may  not  be  out  of  place  to 
call  attention  to  the  mental  qualifications  required  by  one 
who  essays  to  attack  and  determine  accounting  problems. 

These  are :  ability,  coupled  with  tact  and  honesty,  to 
ascertain  facts  without  friction  and  with  impartiality ;  a  mind 
unbiased  by  previous  conceptions,  and  free  to  reach  inde- 
pendent and  reliable  conclusions  of  fact;  and  a  will  strong 
enough  to  maintain  such  conclusions  against  the  arguments, 
opinions,  or  desires  of  opponents  interested  in  some  opposite 
or  inconsistent  conclusion,  and  yet  to  adapt  such  parts  of 
their  arguments  as  may  throw  new  light  on  the  questions  at 
issue.  With  such  qualities,  and  with  the  added  technical 
training  and  practical  experience  which  are  equally  neces- 
sary, the  individual  is  in  fact  an  accountant  qualified  to  deal 
with  the  many  questions  herein  discussed,  and  to  add  new 
principles  to  those  which  it  has  been  the  endeavor  to  illus- 
trate and  explain  in  this  volume. 


249 


APPENDIX  I 

SECTIONS  OF  THE  ENGLISH  LAW  RE- 
LATING  TO    THE    INSPECTION    AND 
AUDIT  OF  ACCOUNTS  [COMPANIES 
(CONSOLIDATION)  ACT,  1908] 

INSPECTION  AND  AUDIT 

( 1 )  The  Board  of  Trade  may  appoint  one  or  Section  109. 
more    competent    inspectors    to    investigate    the 

affairs  of  any  company  and  to  report  thereon  in  tiorTo/^^' 
such  manner  as  the  Board  direct —  affairs  of 

(i)   In  the  case  of  a  banking  company  having  by  "e^oTrd 
a  share  capital,  on  the  application  of  of  Trade 
members   holding  not  less  than   one-  inspectors, 
third  of  the  shares  issued : 
(ii)   In  the  case  of  any  other  company  having 
a  share  capital,  on  the  application  of 
members   holding  not   less   than   one- 
tenth  of  the  shares  issued  : 
(iii)   In  the  case  of  a  company  not  having  a 
share  capital,  on  the  application  of  not 
less  than  one-fifth  in  number  of  the 
persons  on  the  company's  register  of 
members. 

(2)  The  application  shall  be  supported  by 
such  evidence  as  the  Board  of  Trade  may  require 
for  the  purpose  of  showing  that  the  applicants 
have  good  reason  for,  and  are  not  actuated  by 
malicious  motives  in  requiring,  the  investigation; 
and  the  Board  of  Trade  may,  before  appointing 
an  inspector,  require  the  applicants  to  give  secur- 
ity for  payment  of  the  costs  of  the  inquiry. 

2^1 


252     ACCOUNTING    PRACTICE    AND    PROCEDURE 

(3)  It  shall  be  the  duty  of  all  officers  and 
agents  of  the  company  to  produce  to  the  inspectors 
all  books  and  documents  in  their  custody  or 
power. 

(4)  An  inspector  may  examine  on  oath  the 
officers  and  agents  of  the  company  in  relation  to 
its  business,  and  may  administer  an  oath 
accordingly. 

(5)  If  any  officer  or  agent  refuses  to  produce 
any  book  or  document  which  under  this  section 
it  is  his  duty  to  produce,  or  to  answer  any  ques- 
tion relating  to  the  affairs  of  the  company,  he 
shall  be  liable  to  a  fine  not  exceeding  five  pounds 
in  respect  of  each  offence. 

(6)  On  the  conclusion  of  the  investigation  the 
inspectors  shall  report  their  opinion  to  the  Board 
of  Trade,  and  a  copy  of  the  report  shall  be  for- 
warded by  the  Board  to  the  registered  office  of 
the  company,  and  a  further  copy  shall,  at  the 
request  of  the  applicants  for  the  investigation,  be 
dehvered  to  them. 

The  report  shall  be  written  or  printed,  as  the 
Board  direct. 

(7)  All  expenses  of  and  incidental  to  the  in- 
vestigation shall  be  defrayed  by  the  applicants, 
unless  the  Board  of  Trade  direct  the  same  to  be 
paid  by  the  company,  which  the  Board  is  hereby 
authorized  to  do. 

{In  re  Grosvenor  Hotel  Company  an  applica- 
tion to  prohibit  the  Board  of  Trade  and  the 
inspector  appointed  by  them  from  proceeding 
under  this  section  failed.) 


Section  110. 

Power  of 
company 
to  appoint 
inspectors. 


(i)  A  company  may  by  special  resolution 
appoint  inspectors  to  investigate  its  affairs. 

(2)  Inspectors  so  appointed  shall  have  the 
same  powers  and  duties  as  inspectors  appointed  by 
the  Board  of  Trade,  except  that,  instead  of  re- 
porting to  the  Board,  they  shall  report  in  such 


APPENDIX  253 

manner  and  to  such  persons  as  the  company  in 
general  meeting  may  direct. 

(3)  Officers  and  agents  of  the  company  shall 
incur  the  like  penalties  in  case  of  refusal  to  pro- 
duce any  book  or  document  required  to  be  pro- 
duced to  inspectors  so  appointed,  or  to  answer  any 
question,  as  they  would  have  incurred  if  the  in- 
spectors had  been  appointed  by  the  Board  of 
Trade. 

A  copy  of  the  report  of  any  inspectors  ap-  Section  111. 
pointed  under  this  Act,  authenticated  by  the  seal  Report  of 
of  the  company  whose  afifairs  they  have  investi-  inspectors  to 
gated,  shall  be  admissible  in  any  legal  proceeding  be  evidence, 
as  evidence  of  the  opinion  of  the  inspectors  in 
relation  to  any  matter  contained  in  the  report. 

(i)  Every  company  shall  at  each  annual  gen-  Section  112. 

eral  meeting  appoint  an  auditor  or  auditors  to  Appoint- 

hold  office  until  the  next  annual  general  meeting,  ment  and 

(2)  If  an  appointment  of  auditors  is  not  made  remunera- 
at  an  annual  general  meeting,  the  Board  of  Trade  auditors, 
may,  on  the  application  of  any  member  of  the 
company,  appoint  an  auditor  of  the  company  for 

the.  current  year,  and  fix  the  remuneration  to  be 
paid  to  him  by  the  company  for  his  services. 

(3)  A  director  or  officer  of  the  company  shall 
not  be  capable  of  being  appointed  auditor  of  the 
company. 

(4)  A  person,  other  than  a  retiring  auditor, 
shall  not  be  capable  of  being  appointed  auditor 
at  an  annual  general  meeting  unless  notice  of  an 
intention  to  nominate  that  person  to  the  office  of 
auditor  has  been  given  by  a  shareholder  to  the 
company  not  less  than  fourteen  days  before  the 
annual  general  meeting,  and  the  company  shall 
send  a  copy  of  any  such  notice  to  the  retiring 
auditor,  and  shall  give  notice  thereof  to  the  share- 
holders, either  by  advertisement  or  in  any  other 
mode  allowed  by  the  articles,  not  less  than  seven 
days  before  the  annual  general  meeting : 


254    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Provided  that  if,  after  notice  of  the  intention 
to  nominate  an  auditor  has  been  so  given,  an 
annual  general  meeting  is  called  for  a  date  four- 
teen days  or  less  after  the  notice  has  been  given, 
the  notice,  though  not  given  within  the  time  re- 
quired by  this  provision,  shall  be  deemed  to  have 
been  properly  given  for  the  purposes  thereof, 
and  the  notice  to  be  sent  or  given  by  the  com- 
pany may,  instead  of  being  sent  or  given  within 
the  time  required  by  this  provision,  be  sent  or 
given  at  the  same  time  as  the  notice  of  the  an- 
nual general  meeting. 

(5)  The  first  auditors  of  the  company  may 
be  appointed  by  the  directors  before  the  statu- 
tory meeting,*  and  if  so  appointed  shall  hold 
office  until  the  first  annual  general  meeting,  un- 
less previously  removed  by  a  resolution  of  the 
shareholders  in  general  meeting,  in  which  case 
the  shareholders  at  that  meeting  may  appoint 
auditors. 

(6)  The  directors  may  fill  any  casual  vacancy 
in  the  office  of  auditor,  but  while  any  such 
vacancy  continues  the  surviving  or  continuing 
auditor  or  auditors,  if  any,  may  act. 

(7)  The  remuneration  of  the  auditors  of  a 
company  shall  be  fixed  by  the  company  in  gen- 
eral meeting,  except  that  the  remuneration  of 
any  auditors  appointed  before  the  statutory 
meeting,*  or  to  fill  any  casual  vacancy,  may  be 
fixed  by  the  directors. 

Section  113.       (i)  Every  auditor  of  a  company  shall  have  a 

Powers  and    right  of  access  at  all  times  to  the  books  and 

duties  of       accounts   and   vouchers   of  the  company,   and 

auditors.        shall  be  entitled  to  require  from  the  directors 

and  officers  of  the  company  such  information 

and  explanation  as  may  be  necessary  for  the 

performance  of  the  duties  of  the  auditors. 

♦There  is  no  statutory  meeting   except  in  the  case  of 
companies  limited  by  shares. 


APPENDIX  255 

(2)  The  auditors  shall  make  a  report  to  the 
shareholders  on  the  accounts  examined  by  them, 
and  on  every  balance  sheet  laid  before  the  com- 
pany in  general  meeting  during  their  tenure  of 
office,  and  the  report  shall  state — 

(a)  whether  or  not  they  have  obtained  all  the 

information  and  explanations  they  have 
required;  and, 

(b)  whether,    in    their    opinion,    the    balance 

sheet  referred  to  in  the  report  is  prop- 
erly drawn  up  so  as  to  exhibit  a  true 
and  correct  view  of  the  state  of  the 
company's  affairs  according  to  the  best 
of  their  information  and  the  explana- 
tions given  to  them,  and  as  shown  by 
the  books  of  the  company. 

(3)  The  balance  sheet  shall  be  signed  on  be- 
half of  the  board  by  two  of  the  directors  of  the 
company  or,  if  there  is  only  one  director,  by 
that  director,  and  the  auditors'  report  shall  be 
attached  to  the  balance  sheet,  or  there  shall  be 
inserted  at  the  foot  of  the  balance  sheet  a  refer- 
ence to  the  report,  and  the  report  shall  be  read 
before  the  company  in  general  meeting,  and 
shall  be  open  to  inspection  by  any  shareholder. 

Any  shareholder  shall  be  entitled  to  be  fur- 
nished with  a  copy  of  the  balance  sheet  and 
auditors'  report  at  a  charge  not  exceeding  six- 
pence for  every  hundred  words. 

(4)  If  any  copy  of  a  balance  sheet  which  has 
not  been  signed  as  required  by  this  section  is 
issued,  circulated,  or  pubHshed,  or  if  any  copy 
of  a  balance  sheet  is  issued,  circulated,  or  pub- 
lished without  either  having  a  copy  of  the 
auditors'  report  attached  thereto  or  containing- 
such  reference  to  that  report  as  is  required  by 
this  section,  the  company,  and  every  director, 
manager,  secretary,  or  other  officer  of  the  com- 


356      ACCOUNTING    PRACTICE    AND    PROCEDURE 

pany  who  is  knowingly  a  party  to  the  default, 
shall  on  conviction  be  liable  to  a  fine  not  ex- 
ceeding fifty  pounds. 

(5)  In  the  case  of  a  banking  company  reg- 
istered after  the  fifteenth  day  of  August  eight- 
een hundred  and  seventy-nine — 

(a)  if  the  company  has  branch  banks  beyond 

the  limits  of  Europe,  it  shall  be  suffi- 
cient if  the  auditor  is  allowed  access  to 
such  copies  of  and  extracts  from  the 
books  and  accounts  of  any  such  branch 
as  have  been  transmitted  to  the  head 
office  of  the  company  in  the  United 
Kingdom;  and, 

(b)  the  balance  sheet  must  be  signed  by  the 

secretary  or  manager  (if  any),  and 
where  there  are  more  than  three  direc- 
tors of  the  company  by  at  least  three 
of  those  directors,  and  where  there  are 
not  more  than  three  directors  by  all 
the  directors. 

The  Act  by  implication  requires  that  there 
shall  be  annually  an  audit  of  the  accounts  re- 
sulting in  a  balance  sheet  to  whose  accuracy  the 
auditors  shall  certify. 

Regulations  which  compel  the  auditor  to 
withhold  information  which  is  material  to  the 
true  state  of  the  company's  afifairs  are  incon- 
sistent with  the  Act.  The  majority  of  the  share- 
holders may  within  limits  provide  for  secrecy  as 
regards  matters  of  which  knowledge  will  come 
to  the  auditors  in  the  course  of  the  audit,  but 
the  limit  is  passed  if  such  a  secrecy  is  imposed 
as  precludes  the  auditors  from  availing  them- 
selves of  all  the  information  to  which  under  the 
Act  they  are  entitled  as  material  for  the  report 
which  under  the  Act  they  are  to  make  on  the 
company's  affairs. 


APPENDIX  257 

(i)  Holders  of  preference  shares  and  deben-  Section  114. 
tures  of  a  company  shall  have  the  same  right  to  Rights  of 
receive  and  inspect  the  balance  sheets  of  the  preference 
company  and  the  reports  of  the  auditors  and  holders,  etc. 
other  reports  as  is  possessed  by  the  holders  of  as  to  re- 
ordinary  shares  in  the  company.  f  ^'P^  ^^A 
.              .                                                           .  inspection 

(2)  This  section  shall  not  apply  to  a  private  of  reports, 
company,  nor  to  a  company  registered  before  ^^^ 
the  first  day  of  July,  nineteen  hundred  and  eight. 


APPENDIX  II 

EXTRACTS  FROM  SCHEDULE  I  TO 

COMPANIES  (CONSOLIDATION) 

ACT,  1908,  KNOWN  AS 

TABLE  A 

DIVIDENDS  AND  RESERVE 

95.  The  company  in  general  meeting  may  de- 
clare dividends,  but  no  dividend  shall  exceed 
the  amount  recommended  by  the  directors. 

96.  The  directors  may  from  time  to  time  pay 
to  the  members  such  interim  dividends  as  ap- 
pear to  the  directors  to  be  justified  by  the 
profits  of  the  company. 

97.  No  dividend  shall  be  paid  otherwise  than 
out  of  profits. 

98.  Subject  to  the  rights  of  persons,  if  any, 
entitled  to  shares  with  special  rights  as  to  divi- 
dends, all  dividends  shall  be  declared  and  paid 
according  to  the  amounts  paid  on  the  shares, 
but  if  and  so  long  as  nothing  is  paid  up  on  any 
of  the  shares  in  the  company  dividends  may  be 
declared  and  paid  according  to  the  amounts  of 
the  shares.  No  amount  paid  on  a  share  in 
advance  of  calls  shall,  while  carrying  interest,  be 
treated  for  the  purposes  of  this  article  as  paid 
on  the  share. 

99.  The  directors  may,  before  recommending 
any  dividend,  set  aside  out  of  the  profits  of  the 
company  such  sums  as  they  think  proper  as  a 
reserve  or  reserves  which  shall,  at  the  discretion 
of  the  directors,  be  applicable  for  meeting  con- 

258 


APPENDIX  259 

tingencies,  or  for  equalizing  dividends,  or  for 
any  other  purpose  to  which  the  profits  of  the 
company  may  be  properly  applied,  and  pending 
such  application  may,  at  the  like  discretion, 
either  be  employed  in  the  business  of  the  com- 
pany or  be  invested  in  such  investments  (other 
than  shares  of  the  company)  as  the  directors 
may  from  time  to  time  think  fit. 

100.  If  several  persons  are  registered  as  joint 
holders  of  any  share  any  one  of  them  may  give 
effectual  receipts  for  any  dividend  payable  on 
the  share. 

loi.  Notice  of  any  dividend  that  may  have 
been  declared  shall  be  given  in  manner  herein- 
after mentioned  to  the  persons  entitled  to  share 
therein. 

102.  No  dividend  shall  bear  interest  against 
the  company. 

ACCOUNTS 

103.  The  directors  shall  cause  true  accounts 
to  be  kept — 

Of  the  sums  of  money  received  and  expended 
by  the  company  and  the  matter  in  respect  of 
which  such  receipt  and  expenditure  takes  place, 
and 

Of  the  assets  and  liabilities  of  the  company. 

104.  The  books  of  account  shall  be  kept  at 
the  registered  office  of  the  company,  or  at  such 
other  place  or  places  as  the  directors  think  fit, 
and  shall  always  be  open  to  the  inspection  of  the 
directors. 

105.  The  directors  shall  from  time  to  time 
determine  whether  and  to  what  extent  and  at 
what  times  and  places  and  under  what  condi- 
tions or  regulations  the  accounts  and  books  of 
the  company  or  any  of  them  shall  be  open  to 
the  inspection  of  members  not  being  directors, 
and  no  member  (not  being  a  director)  shall  have 


26o   ACCOUNTING    PRACTICE    AND    PROCEDURE 

any  right  of  inspecting  any  account  or  book  or 
document  of  the  company  except  as  conferred 
by  statute  or  authorized  by  the  directors  or  by 
the  company  in  general  meeting. 

1 06.  Once  at  least  in  every  year  the  directors 
shall  lay  before  the  company  in  general  meeting 
a  profit  and  loss  account  for  the  period  since 
the  preceding  account  or  (in  the  case  of  the 
first  account)  since  the  incorporation  of  the 
company,  made  up  to  a  date  not  more  than  six 
months  before  such  meeting. 

107.  A  balance  sheet  shall  be  made  out  in 
every  year  and  laid  before  the  company  in  gen- 
eral meeting  made  up  to  a  date  not  more  than 
six  months  before  such  meeting.  The  balance 
sheet  shall  be  accompanied  by  a  report  of  the 
directors  as  to  the  state  of  the  company's  affairs, 
and  the  amount  which  they  recommend  to  be 
paid  by  way  of  dividend,  and  the  amount,  if 
any,  which  they  propose  to  carry  to  a  reserve 
fund. 

108.  A  copy  of  the  balance  sheet  and  report 
shall,  seven  days  previously  to  the  meeting,  be 
sent  to  the  persons  entitled  to  receive  notices 
of  general  meetings  in  the  manner  in  which 
notices  are  to  be  given  hereunder. 


APPENDIX  III 

SECTIONS    OF    THE    ENGLISH    LAW 

RELATING      TO      PROSPECTUSES 

[COMPANIES  (CONSOLIDATION) 

ACT,   1908] 

PROSPECTUS 

(i)  Every  prospectus  issued  by  or  on  behalf   Section  80. 
of  a  company  or  in  relation  to  any  intended   pj|j„g  of 
company  shall  be  dated,  and  that  date  shall,  un-  prospec- 
less  the  contrary  be  proved,  be  taken  as  the  date  t"^- 
of  publication  of  the  prospectus. 

(2)  A  copy  of  every  such  prospectus,  signed 
by  every  person  who  is  named  therein  as  a  di- 
rector or  proposed  director  of  the  company,  or 
by  his  agent  authorized  in  writing,  shall  be 
filed  for  regis-tration  with  the  registrar  of  com- 
panies on  or  before  the  date  of  its  publication, 
and  no  such  prospectus  shall  be  issued  until  a 
copy  thereof  has  been  so  filed  for  registration. 

(3)  The  registrar  shall  not  register  any  pros- 
pectus unless  it  is  dated,  and  the  copy  thereof 
signed,  in  manner  required  by  this  section. 

(4)  Every  prospectus  shall  state  on  the  face 
of  it  that  a  copy  has  been  filed  for  registration 
as  required  by  this  section. 

(5)  If  a  prospectus  is  issued  without  a  copy 
thereof  being  so  filed,  the  company  and  every 
person  who  is  knowingly  a  party  to  the  issue  of 
the  prospectus,  shall  be  liable  to  a  fine  not  ex- 
ceeding five  pounds  for  every  day  from  the  date 
of  the  issue  of  the  prospectus  until  a  copy 
thereof  is  so  filed. 

261 


262    ACCOUNTING    PRACTICE    AND    PROCEDURE 

Section  81.        (i)  Every  prospectus  issued  by  or  on  behalf 
_      ..  of  a  company,  or  by  or  on  behalf  of  any  person 

require-         who  is  or  has  been  engaged  or  interested  in  the 
ments  as  to  formation  of  the  company,  must  state — 

of  prospec-        (^)   the  contents  of  the  memorandum,   with 
tus.  the  names,  descriptions,  and  addresses  of  the 

signatories,  and  the  number  of  shares  subscribed 
for  by  them  respectively;  and  the  number  of 
founders  or  management  or  deferred  shares,  if 
any,  and  the  nature  and  extent  of  the  interest 
of  the  holders  in  the  property  and  profits  of  the 
company;  and 

(b)  the  number  of  shares,  if  any,  fixed  by  the 
articles  as  the  qualification  of  a  director,  and 
any  provision  in  the  articles  as  to  the  remunera- 
tion of  the  directors;  and 

(c)  the  names,  descriptions,  and  addresses  of 
the  directors  or  proposed  directors;  and 

(d)  the  minimum  subscription  on  which  the 
directors  may  proceed  to  allotment,  and  the 
amount  payable  on  application  and  allotment 
on  each  share;  and  in  the  case  of  a  second  or 
subsequent  offer  of  shares,  the  amount  offered 
for  subscription  on  each  previous  allotment 
made  within  the  two  preceding  years,  and  the 
amount  actually  allotted,  and  the  amount,  if 
any,  paid  on  the  shares  so  allotted;  and 

(e)  the  number  and  amount  of  shares  and 
debentures  which  within  the  two  preceding 
years  have  been  issued,  or  agreed  to  be  issued, 
as  fully  or  partly  paid  up  otherwise  than  in  cash, 
and  in  the  latter  case  the  extent  to  which  they 
are  so  paid  up,  and  in  either  case  the  considera- 
tion for  which  those  shares  or  debentures  have 
been  issued  or  are  proposed  or  intended  to  be 
issued;  and 

(f)  the  names  and  addresses  of  the  vendors 
of  any  property  purchased  or  acquired  by  the 
company,  or  proposed  so  to  be  purchased  or 


APPENDIX  263 

acquired,  which  is  to  be  paid  for  wholly  or  partly 
out  of  the  proceeds  of  the  issue  offered  for  sub- 
scription by  the  prospectus,  or  the  purchase  or 
acquisition  of  which  has  not  been  completed  at 
the  date  of  issue  of  the  prospectus,  and  the 
amount  payable  in  cash,  shares,  or  debentures, 
to  the  vendor,  and  where  there  is  more  than 
one  separate  vendor,  or  the  company  is  a  sub- 
purchaser, the  amount  so  payable  to  each  vendor : 
Provided  that  where  the  vendors  or  any  of  them 
are  a  firm  the  members  of  the  firm  shall  not  be 
treated  as  separate  vendors;  and 

(g)  the  amount  (if  any)  paid  or  payable  as 
purchase-money  in  cash,  shares,  or  debentures, 
for  any  such  property  as  aforesaid,  specifying 
the  amount  (if  any)  payable  for  good-will;  and 

(h)  the  amount  (if  any)  paid  within  the  two 
preceding  years,  or  payable,  as  commission  for 
subscribing  or  agreeing  to  subscribe,  or  pro- 
curing or  agreeing  to  procure  subscriptions,  for 
any  shares  in,  or  debentures  of,  the  company,  or 
the  rate  of  any  such  commission:  Provided  that 
it  shall  not  be  necessary  to  state  the  commission 
payable  to  sub-underwriters;  and 

(i)  the  amount  or  estimated  amount  of  pre- 
liminary expenses;  and 

(j)  the  amount  paid  within  the  two  preceding 
years  or  intended  to  be  paid  to  any  promoter, 
and  the  consideration  for  any  such  payment; 
and 

(k)  the  dates  of  and  parties  to  every  material 
contract,  and  a  reasonable  time  and  place  a\ 
which  any  material  contract  or  a  copy  thereof 
may  be  inspected:  Provided  that  this  require- 
ment shall  not  apply  to  a  contract  entered  into 
in  the  ordinary  course  of  the  business  carried  on 
or  intended  to  be  carried  on  by  the  company, 
or  to  any  contract  entered  into  more  than  two 


264     ACCOUNTING    PRACTICE    AND    PROCEDURE 

years  before  the  date  of  issue  of  the  prospectus; 
and 

(1)  the  names  and  addresses  of  the  auditors  (if 
any)  of  the  company;  and 

(m)  full  particulars  of  the  nature  and  extent 
of  the  interest  (if  any)  of  every  director  in  the 
promotion  of,  or  in  the  property  proposed  to  be 
acquired  by,  the  company,  or,  where  the  interest 
of  such  a  director  consists  in  being  a  partner  in 
a  firm,  the  nature  and  extent  of  the  interest  of 
the  firm,  with  a  statement  of  all  sums  paid  or 
agreed  to  be  paid  to  him  or  to  the  firm  in  cash 
or  shares  or  otherwise  by  any  person  either  to 
induce  him  to  become,  or  to  qualify  him  as,  a 
director,  or,  otherwise  for  services  rendered  by 
him  or  by  the  firm  in  connection  with  the  pro- 
motion or  formation  of  the  company;  and 

(n)  where  the  company  is  a  company  having 
shares  of  more  than  one  class,  the  right  of  vot- 
ing at  meetings  of  the  company  conferred  by 
the  several  classes  of  shares  respectively. 

(2)  For  the  purposes  of  this  section  every 
person  shall  be  deemed  to  be  a  vendor  who  has 
entered  into  any  contract,  absolute  or  condi- 
tional, for  the  sale  or  purchase,  or  for  any  op- 
tion of  purchase,  of  any  property  to  be  acquired 
by  the  company,  in  any  case  where — 

(a)  the  purchase-money  is  not  fully  paid  at 
the  date  of  issue  of  the  prospectus;  or 

(b)  the  purchase-money  is  to  be  paid  or  satis- 
fied wholly  or  in  part  out  of  the  proceeds  of  the 
issue  offered  for  subscription  by  the  prospectus; 
or 

(c)  the  contract  depends  for  its  validity  or 
fulfilment  on  the  result  of  that  issue. 

(3)  Where  any  of  the  property  to  be  acquired 
by  the  company  is  to  be  taken  on  lease,  this 
section  shall  apply  as  if  the  expression  "vendor" 


APPENDIX  265 

included  the  lessor,  and  the  expression  "pur- 
chase-money" included  the  consideration  for  the 
lease,  and  the  expression  "sub-purchaser"  in- 
cluded a  sublessee. 

(4)  Any  condition  requiring  or  binding  any 
applicant  for  shares  or  debentures  to  waive 
compliance  with  any  requirement  of  this  sec- 
tion, or  purporting  to  afTect  him  with  notice 
of  any  contract,  document,  or  matter  not  spe- 
cifically referred  to  in  the  prospectus,  shall  be 
void. 

(5)  Where  any  such  prospectus  as  is  men- 
tioned in  this  section  is  published  as  a  newspaper 
advertisement,  it  shall  not  be  necessary  in  the 
advertisement  to  specify  the  contents  of  the 
memorandum  or  the  signatories  thereto,  and 
the  number  of  shares  subscribed  for  by  them. 

(6)  In  the  event  of  non-compliance  with  any 
of  the  requirements  of  this  section,  a  director 
or  other  person  responsible  for  the  prospectus 
shall  not  incur  any  liability  by  reason  of  the 
non-compliance,  if  he  proves  that — 

(a)  as  regards  any  matter  not  disclosed,  he 
was  not  cognizant  thereof;  or 

(b)  the  non-compliance  arose  from  an  honest 
mistake  of  fact  on  his  part: 

Provided  that  in  the  event  of  non-compliance 
with  the  requirements  contained  in  paragraph 
(m)  of  sub-section  (i)  of  this  section  no  director 
or  other  person  shall  incur  any  liability  in  re- 
spect of  the  non-compliance  unless  it  be  proved 
that  he  had  knowledge  of  the  matters  not 
disclosed. 

(7)  This  section  shall  not  apply  to  a  circular 
or  notice  inviting  existing  members  or  deben- 
ture holders  of  a  company  to  subscribe  either 
for  shares  or  for  debentures  of  the  company, 
whether  with  or  without  the  right  to  renounce 


266      ACCOUNTING    PRACTICE    AND    PROCEDURE 

in  favor  of  other  persons,  but  subject  as  afore- 
said, this  section  shall  apply  to  any  prospectus 
whether  issued  on  or  with  reference  to  the 
formation  of  a  company  or  subsequently. 

(8)  The  requirements  of  this  section  as  to  the 
memorandum  and  the  qualification,  remunera- 
tion, and  interest  of  directors,  the  names,  de- 
scriptions and  addresses  of  directors  or  proposed 
directors,  and  the  amount  or  estimated  amount 
of  preliminary  expenses,  shall  not  apply  in  the 
case  of  a  prospectus  issued  more  than  one  year 
after  the  date  at  which  the  company  is  entitled 
to  commence  business. 

(9)  Nothing  in  this  section  shall  limit  or 
diminish  any  liability  which  any  person  may  in- 
cur under  the  general  law  or  this  Act  apart  from 
this  section. 


Section  82. 

Obliga- 
tions  of 
companies 
where   no 
prospectus 
is  issued. 


Section  83. 

Restriction 
on  altera- 
tion  of 
terms  men- 
tioned  in 
prospectus 
or  state- 
ment  in 
lieu   of 
prospectus. 


(i)  A  company  which  does  not  issue  a  pros- 
pectus on  or  with  reference  to  its  formation, 
shall  not  allot  any  of  its  shares  or  debentures 
unless  before  the  first  allotment  of  either  shares 
or  debentures  there  has  been  filed  with  the  regis- 
trar of  companies  a  statement  in  lieu  of  pros- 
pectus signed  by  every  person  who  is  named 
therein  as  a  director  or  a  proposed  director  of 
the  company  or  by  his  agent  authorized  in 
writing,  in  the  form  and  containing  the  particu- 
lars set  out  in  the  Second  Schedule  to  this  Act, 

(2)  This  section  shall  not  apply  to  a  private 
company  or  to  a  company  which  has  allotted 
any  shares  or  debentures  before  the  first  day  of 
July,  nineteen  hundred  and  eight. 

A  company  shall  not  previously  to  the  statu- 
tory meeting  vary  the  terms  of  a  contract  re- 
ferred to  in  the  prospectus  or  statement  in  lieu 
of  prospectus,  except  subject  to  the  approval  of 
the  statutory  meeting. 


APPENDIX 


267 


Liability 
for    state- 
ments   in 
prospectus. 


(i)  Where  a  prospectus  invites  persons  to  Section  84, 
subscribe  for  shares  in  or  debentures  of  a  com- 
pany, every  person  who  is  a  director  of  the  com- 
pany at  the  time  of  the  issue  of  the  prospectus, 
and  every  person  who  has  authorized  the  nam- 
ing of  him  and  is  named  in  the  prospectus  as  a 
director  or  as  having  agreed  to  become  a  di- 
rector either  immediately  or  after  an  interval 
of  time,  and  every  promoter  of  the  company, 
and  every  person  who  has  authorized  the  issue 
of  the  prospectus,  shall  be  liable  to  pay  compen- 
sation to  all  persons  who  subscribe  for  any 
sha.res  or  debentures  on  the  faith  of  the  pros- 
pectijs  for  the  loss  or  da'mage  they  may  have 
sustained  by  reason  of  any  untrue  statement 
therein,  or  in  any  report  or  memorandum  ap- 
pearing on  the  face  thereof,  or  by  feference  in- 
corporated therein  or  issued  therewith,  unless 
it  is  proved — 

(a)  with  respect  to  every  untrue  statement 
not  purporting  to  be  made  on  the  authority  of 
an  expert,  or  of  a  public  official  document  or 
statement,  that  he  had  reasonable  ground  to 
believe,  and  did  up  to  the  time  of  the  allotment 
of  the  shares  or  debentures,  as  the  case  may  be, 
believe,  that  the  statement  was  true;  and 

(b)  with  respect  to  every  untrue  statement 
purporting  to  be  a  statement  by  or  contained 
in  what  purports  to  be  a  copy  of  or  extract 
from  a  report  or  valuation  of  an  expert,  that  it 
fairly  represented  the  statement,  or  was  a  cor- 
rect and  fair  copy  of  or  extract  from  the  report 
or  valuation.  Provided  that  the  director,  per- 
son named  as  director,  promoter,  or  person  who 
authorized  the  issue  of  the  prospectus,  shall  be 
liable  to  pay  compensation  as  aforesaid  if  it  is 
proved  that  he  had  no  reasonable  ground  to  be- 
lieve that  the  person  making  the  statement, 
report,  or  valuation  was  competent  to  make  it; 
and 


268      ACCOUNTING    PRACTICE    AND    PROCEDURE 

(c)  with  respect  to  every  untrue  statement 
purporting  to  be  a  statement  made  by  an  official 
person  or  contained  in  what  purports  to  be  a 
copy  of  or  extract  from  a  public  official  docu- 
ment, that  it  was  a  correct  and  fair  representa- 
tion of  the  statement  or  copy  of  or  extract  from 
the  document: 
or  unless  it  is  proved — 

(i)  that  having  consented  to  become  a  direc- 
tor of  the  company  he  withdrew  his  consent 
before  the  issue  of  the  prospectus,  and  that  it 
was  issued  without  his  authority  or  consent;  or 

(ii)  that  the  prospectus  was  issued  without 
his  knowledge  or  consent,  and  that  on  becoming 
aware  of  its  issue  he  forthwith  gave  reasonable 
public  notice  that  it  was  issued  without  his 
knowledge  or  consent;  or 

(iii)  that  after  the  issue  of  the  prospectus  and 
before  allotment  thereunder,  he,  on  becoming 
aware  of  any  untrue  statement  therein,  with- 
drew his  consent  thereto,  and  gave  reasonable 
public  notice  of  the  withdrawal,  and  of  the 
reason  therefor, 

(2)  Where  a  company  existing  on  the  eigh- 
teenth day  of  August,  one  thousand  eight  hun- 
dred and  ninety,  has  issued  shares  or  debentures, 
and  for  the  purpose  of  obtaining  further  capital 
by  subscriptions  for  shares  or  debentures  issues 
a  prospectus,  a  director  shall  not  be  liable  in 
respect  of  any  statement  therein,  unless  he  has 
authorized  the  issue  of  the  prospectus,  or  has 
adopted  or  ratified  it. 

(3)  Where  the  prospectus  contains  the  name 
of  a  person  as  a  director  of  the  company,  or  as 
having  agreed  to  become  a  director  thereof,  and 
he  has  not  consented  to  become  a  director,  or 
has  withdrawn  his  consent  before  the  issue  of 
the  prospectus,  and  has  not  authorized  or  con- 
sented to  the  issue  thereof,  the  directors  of  the 


APPENDIX  269 

company,  except  any  without  whose  knowledge 
or  consent  the  prospectus  was  issued,  and  any 
other  person  who  authorized  the  issue  thereof, 
shall  be  liable  to  indemnify  the  person  named  as 
aforesaid  against  all  damages,  costs,  and  ex- 
penses to  which  he  may  be  made  liable  by  reason 
of  his  name  having  been  inserted  in  the  pros- 
pectus, or  in  defending  himself  against  any  ac- 
tion or  legal  proceedings  brought  against  him 
in  respect  thereof. 

(4)  Every  person  who  by  reason  of  his  being 
a  director,  or  named  as  a  director,  or  as  having 
agreed  to  become  a  director,  or  of  his  having 
authorized  the  issue  of  the  prospectus,  becomes 
liable  to  make  any  payment  under  this  section 
may  recover  contribution,  as  in  cases  of  con- 
tract, from  any  other  person  who,  if  sued  sepa- 
rately, would  have  been  liable  to  make  the  same 
payment,  unless  the  person  who  has  become  so 
liable  was,  and  that  other  person  was  not,  guilty 
of  fraudulent  misrepresentation. 

(5)  For  the  purposes  of  this  section — 

The  expression  "promoter"  means  a  promoter 
who  was  a  party  to  the  preparation  of  the 
prospectus,  or  of  the  portion  thereof  con- 
taining the  untrue  statement,  but  does  not 
include  any  person  by  reason  of  his  acting 
in  a  professional  capacity  for  persons  en- 
gaged in  procuring  the  formation  of  the 
company: 

The  expression  "expert"  includes  engineer, 
valuer,  accountant,  and  any  other  person 
whose  profession  gives  authority  to  a  state- 
ment made  by  him. 


APPENDIX  IV 

SECTIONS  OF  THE  ENGLISH  LAW  RE- 
LATING TO  PAYMENT  OF  INTEREST 
OUT   OF  CAPITAL    [COMPANIES 
(CONSOLIDATION)  ACT,  1908] 

PAYMENT  OF  INTEREST  OUT  OF  CAPITAL 

Section  91.         Where  any  shares  of  a  company  are  issued  for 
p  ,      the   purpose   of  raising   money   to   defray   the 

company  to  expenses  of  the  construction  of  any  works  or 
pay  interest   buildings  or  the  provision  of  any  plant  which 
ital  ?n  cer-  cannot    be   made   profitable   for   a   lengthened 
tain  cases,     period,   the  company  may  pay  interest   on  so 
much  of  that  share  capital  as  is  for  the  time 
being  paid  up  for  the  period  and  subject  to  the 
conditions  and  restrictions  in  this  section  men- 
tioned, and  may  charge  the  same  to  capital  as 
part  of  the  cost  of  construction  of  the  work  or 
building,  or  the  provision  of  plant: 
Provided  that — 

(i)  No  such  payment  shall  be  made  unless  the 
same  is  authorized  by  the  articles  or 
by  special  resolution: 

(2)  No  such  payment,  whether  authorized  by 

the  articles  or  by  special  resolution, 
shall  be  made  without  the  previous 
sanction  of  the  Board  of  Trade: 

(3)  Before  sanctioning  any  such  payment  the 

Board  of  Trade  may,  at  the  expense  of 
the  company,  appoint  a  person  to  in- 
quire and  report  to  them  as  to  the 
circumstances  of  the  case,  and  may, 
270 


APPENDIX  271 

before  making  the  appointment,  re- 
quire the  company  to  give  security  for 
the  payment  of  the  costs  of  the  inquiry: 

(4)  The  payment  shall  be  made  only  for  such 

period  as  may  be  determined  by  the 
Board  of  Trade;  and  such  period  shall 
in  no  case  extend  beyond  the  close  of 
the  half  year  next  after  the  half  year 
during  which  the  works  or  buildings 
have  been  actually  completed  or  the 
plant  provided: 

(5)  The  rate  of  interast  shall  in  no  case  ex- 

ceed four  per  cent  per  annum  or  such 
lower  rate  as  may  for  the  time  being 
be  prescribed  by  Order  in  Council: 

(6)  The   payment   of  the   interest   shall  not 

operate  as  a  reduction  of  the  amount 
paid  up  on  the  shares  in  respect  of 
which  it  is  paid: 

(7)  The  accounts  of  the  company  shall  show 

the  share  capital  on  which,  and  the 
rate  at  which,  interest  has  been  paid 
out  of  capital  during  the  period  to 
which  the  accounts  relate: 

(8)  Nothing  in  this  section  shall  afifect  any 

company  to  which  the  Indian  Rail- 
ways Act,  1894,  as  amended  by  any 
subsequent  enactment,  applies. 


APPENDIX  V 

SECTIONS   RELATING  TO  SHARE- 
HOLDERS'   AUDIT    IN    THE 
CANADIAN    BANK   ACT, 
1913 


Selection 
of  persons 
competent 
to  be 
auditors. 


List  to  be 
sent  to 
Minister. 


SHAREHOLDERS    AUDIT 

56.  The  general  managers  of  the  banks  (or  in 
the  absence  of  a  general  manager  of  any  bank 
the  official  designated  by  him,  or  in  default  of 
such  designation  the  principal  officer  of  the  bank 
next  in  authority)  shall,  at  a  meeting  duly  called 
by  the  president  of  the  Association  for  the  pur- 
pose before  the  thirtieth  day  of  September  nine- 
teen hundred  and  thirteen,  and  thereafter  before 
the  thirtieth  day  of  June  in  each  year,  select  by 
ballot  persons  deemed  by  them  to  be  competent 
(no  one  of  whom  shall  be  a  body  corporate)  not 
less  than  forty  in  number,  any  one  of  whom 
shall,  subject  to  the  provisions  hereinafter  con- 
tained, be  eligible  to  be  appointed  an  auditor 
under  the  provisions  of  this  Act. 

2.  A  list  of  persons  so  selected,  together  with 
their  post  office  addresses  and  occupations,  shall 
forthwith  be  delivered  or  sent  by  registered  post 
to  the  Minister,  and  the  Minister  may,  in  the 
case  of  the  first  selection,  as  hereinbefore  pro- 
vided, within  ten  days  after  the  receipt  of  the 
list,  and  thereafter  each  year  within  sixty  days 
after  the  receipt  thereof,  disapprove,  as  to  eligi- 
bilty  to  be  appointed  auditor  of  a  particular 
bank  or  banks,  or  wholly  disapprove,  of  the 
selection  of  any  person  named  in  the  list,  and 
272 


APPENDIX  273 

such  person  shall  not,  to  the  extent  of  such 
disapproval,  be  qualified  to  be  appointed  an 
auditor  under  this  section. 

3.  The  Minister  shall  communicate  his  disap-  Disapproval, 
proval,  if  any,  to  the  Association.  ^^  ^"y- 

4.  The  Association  shall,  as  soon  as  may  be  Publication 
after  the  expiry  of  the  time  given  to  the  Min-  "^^^52"^^ 
ister  for  disapproval,  cause  the  list  of  persons 
qualified  as  hereinbefore  provided,   with   their 
respective  post  office  addresses  and  occupations, 

to  be  published  in  two  successive  issues  of  The 
Canada  Gazette,  and  any  limitation  as  to  eligi- 
bility for  the  auditorship  of  a  particular  bank 
or  banks  of  the  persons  named  in  the  list  shall 
be  stated  in  the  advertisement. 

5.  No  person  shall  be  qualified  to  act  as  an  Qualifica- 
auditor  of  a  bank  under  this  Act  unless  his  name  tion  of 
appears  in  the  published  list  for  the  year,  but 

this  subsection  shall  not  apply  to  an  appoint- 
ment of  an  auditor  made  by  the  Minister  in  pur- 
suance of  the  provisions  of  this  Act. 

6.  The  shareholders  shall,  at  each  annual  gen-  Appoint- 
eral  meeting,  appoint  an  auditor  or  auditors,  "^^"'  °^ 
from  the  last  published  list  of  persons  qualified, 

to  hold  office  until  the  next  annual  general 
meeting. 

7.  After  the  appointment   of  an  auditor  or  Super- 
auditors  under  the  next  preceding  subsection  session  of 
of  this  section,  shareholders,  the  aggregate  of 

whose  paid-up  capital  stock  is  equal  to  at  least 
one-third  of  the  paid-up  capital  stock  of  the 
bank,  who  in  writing  under  their  respective 
hands  allege  that  they  are  dissatisfied  with  the 
appointment  so  made,  may,  in  and  by  the  same 
writing,  make  application  to  the  Minister  to 
have  the  person  or  persons  so  appointed  super- 
seded, and  the  Minister  may,  after  such  inquiry 
as  he  may  deem  necessary,  select  an  auditor  or 


274   ACCOUNTING    PRACTICE    AND    PROCEDITRE 


auditors  instead  of  the  auditor  or  auditors  ap- 
pointed at  the  annual  general  meeting,  and  the 
auditors  so  appointed  shall  thereupon  cease  to 
be  the  auditors  of  the  bank  and  the  auditors  so 
selected  shall  be  the  auditors  of  the  bank  until 
the  next  annual  general  meeting. 

8.  If  an  appointment  of  auditors  is  not  made 
at  an  annual  general  meeting,  the  Minister  shall, 
on  the  written  application  of  a  shareholder,  ap- 
point an  auditor  or  auditors  of  the  bank  to  hold 
office  until  the  next  annual  general  meeting,  and 
the  Governor  in  Council  shall  fix  the  remunera- 
tion to  be  paid  by  the  bank  for  the  services  of 
the  auditor  or  auditors  so  appointed. 

Officers  dis-       9-  A  director  or  officer  of  the  bank  shall  not 
qualified.       be  capable  of  being  appointed  auditor  of  the 
bank. 


Appoint- 
ment by 
Minister  on 
application 
of  share- 
holder. 


Notice 
required  of 
intention  to 
nominate 
auditor. 


Retiring 

auditor 

notified. 


Notice  to 
share- 
holders. 


Vacancies. 


10.  A  person,  other  than  a  retiring  auditor, 
shall  not  be  capable  of  being  appointed  auditor 
at  an  annual  general  meeting  unless  written 
notice  of  an  intention  to  nominate  that  person 
to  the  office  of  auditor  has  been  given  by  a 
shareholder  to  the  bank  at  its  chief  office,  not 
less  than  twenty-one  days  before  the  annual 
general  meeting,  and  the  bank  shall  deliver  a 
copy  of  any  such  notice  to  the  retiring  auditor, 
if  any,  and  shall  give  notice  of  the  names  of 
the  persons  eligible  for  nomination  at  the  said 
meeting,  and  by  whom  such  persons  are  re- 
spectively intended  to  be  nominated,  to  every 
shareholder  of  the  bank,  by  mailing  the  notice 
in  the  post  office,  post  paid,  to  the  last  known 
post  office  address  of  the  shareholder  as  shown 
by  the  records  of  the  bank,  at  least  fourteen 
days  prior  to  the  annual  general  meeting. 

11.  If  any  casual  vacancy  occurs  in  the  office 
of  auditor  the  surviving  or  continuing  auditor 
or  auditors,  if  any,  may  act,  but  if  there  is  no 


APPENDIX 


275 


surviving  or  continuing  auditor,  and  such  va- 
cancy has  occurred  more  than  three  months  be- 
fore the  annual  general  meeting,  the  directors  Special 
shall,  as  hereafter  in  this  section  provided,  call  meeting, 
a  special  general  meeting  of  the  shareholders  for 
the  purpose  of  filling  the  vacancy. 

12.  Before  calling  such  special  general  meet-  Public 
ing  the  directors  shall,  as  soon  as  may  be  after  notice  by 
the  vacancy  occurs,  give  public  notice  by  ad-  ment. 
vertisement  in  six  consecutive  issues  of  one  or 

more  daily  newspapers  published  in  the  place 
where  the  chief  office  of  the  bank  is  situate,  and 
if  no  daily  newspaper  is  published  at  that  place, 
then  by  advertisement  in  two  consecutive  issues 
of  a  newspaper  published  weekly  in  that  place, 
of  the  vacancy  in  the  office  of  auditor,  and  that 
the  vacancy  will  be  filled  in  the  manner  provided 
by  this  Act. 

13.  A  person  shall  not  be  capable  of  being  ap- 
pointed auditor  to  fill  such  vacancy  unless 
notice  of  an  intention  to  nominate  that  person 
to  the  office  of  auditor  has  been  given  by  a 
shareholder  to  the  bank  at  its  chief  office  within 
ten  days  after  the  last  publication  of  the  notice 
called  for  by  the  next  preceding  subsection. 

14.  The  directors   shall,   as   soon  as  may  be  Special 
after  the  expiry  of  the  ten  days  mentioned  in   general 
the  next  preceding  subsection,  call  a  special  gen-  "^^^  '"^* 
eral  meeting  of  the  shareholders  for  the  purpose 

of  filling  the  vacancy,  and  notice  of  such  meet-  Notice  to 
ing,  specifying  the  object,  and  stating  the  names  share- 
of  the  persons  eligible  for  nomination,  and  by  "Aiders, 
whom  such  persons  are  respectively  intended  to 
be  nominated,   shall  be  given  to  every  share- 
holder of  the  bank  by  mailing  the  notice  in  the 
post  office,  post  paid,  to  the  last  known  post 
office  address  of  the  shareholder  as  shown  by 
the  records  of  the  bank,  at  least  fourteen  days 
prior  to  the  date  fixed  for  the  meeting. 


Notice  of 
nomination 
to  fill 
vacancy. 


2^6     ACCOUNTING    PRACTICE    AND    PROCEDURE 


Appoint- 
ment of 
auditor  by- 
Minister  in 
case  of 
vacancy. 


Remunera- 
tion. 


Powers  and 
rights  of 
auditors. 


Audit  of 
branches  or 
agencies. 


15.  If  the  vacancy  contemplated  by  subsec- 
tion II  of  this  section  is  not  filled  in  the  man- 
ner provided,  or  if  a  casual  vacancy  occurs  in 
the  office  of  auditor  less  than  three  months  be- 
fore the  annual  general  meeting,  the  Minister  in 
the  former  case  shall,  and  in  the  latter  case  may, 
on  the  written  application  of  a  shareholder,  ap- 
point an  auditor  or  auditors  to  hold  office  until 
the  next  annual  general  meeting,  and  the  Gov- 
ernor in  Council  shall  fix  the  remuneration  to 
be  paid  by  the  bank  for  the  services  of  the 
auditor  or  auditors  so  appointed. 

16.  The  remuneration  of  auditors  appointed 
by  the  shareholders  shall  be  fixed  by  the  share- 
holders at  the  time  of  their  appointment,  and  in 
the  event  of  such  appointees  being  superseded 
and  other  auditors  selected,  as  provided  by  sub- 
section 7  of  this  section,  the  remuneration  so 
fixed  shall  be  divided  between  them  according 
to  the  length  of  time  they  respectively  are 
auditors  of  the  bank. 

17.  Every  auditor  of  a  bank  shall  have  a 
right  of  access  to  the  books  and  accounts,  cash, 
securities,  documents  and  vouchers  of  the  bank, 
and  shall  be  entitled  to  require  from  the  direc- 
tors and  officers  of  the  bank  such  information 
and  explanation  as  may  be  necessary  for  the 
performance  of  the  duties  of  the  auditors. 

18.  If  the  bank  has  branches  or  agencies  it 
shall  be  sufficient  for  all  the  purposes  of  this 
section  if  the  auditors  are  allowed  access  to  the 
returns,  reports  and  statements  and  to  such 
copies  of  extracts  from  the  books  and  accounts 
of  any  such  branch  or  agency  as  have  been  trans- 
mitted to  the  chief  office,  but  the  auditors  may  in 
their  discretion  visit  any  branch  or  agency  for  the 
purpose  of  examining  the  books  and  accounts, 
cash,  securities,  documents  and  vouchers  at  the 
branch  or  agency. 


APPENDIX  277 

19.  It  shall  be  the  duty  of  the  auditors  once  Duty  of 
at  least  during  their  term  of  office,  in  addition  *H^'*°''^*° 
to  such  checking  and  verification  as  may  be  and%e^tfy 
necessary  for  their  report  upon  the  statement  securities, 
submitted  to  the  shareholders  under  section  54 

of  this  Act,  and  at  a  different  time,  to  check  the 
■cash  and  verify  the  securities  of  the  bank  at  the 
chief  office  of  the  bank  against  the  entries  in 
regard  thereto  in  the  books  of  the  bank,  and, 
should  they  deem  it  advisable,  to  check  and 
verify  in  the  same  manner  the  cash  and  securi- 
ties at  any  branch  or  agency. 

20.  The  auditors  shall  make  a  repor*:  to  the  Report  of 
shareholders —  auditors  to 

(a)  on  the  accounts  examined  by  them ;  holders. 

(b)  on  the  checking  of  cash  and  verification 

of  securities  referred  to  in  the  next  pre- 
ceding subsection;  and, 

(c)  on  the   statement   of  the   affairs  of  the 

bank  submitted  by  the  directors  to  the 
shareholders  under  section  54  of  this 
Act  during  their  tenure  of  office; 
and  the  report  shall  state — 

(a)  whether  or  not  they  have  obtained  all  the  Particalars. 
i  information  and  explanation  they  have 

required; 

(b)  whether,    in   their   opinion,   the   transac- 

tions of  the  bank  which  have  come  un- 
der their  notice  have  been  within  the 
powers  of  the  bank; 

(c)  whether  their  checking  of  cash  and  veri- 

fication of  securities  required  by  sub- 
section 19  of  this  section  agreed  with 
the  entries  in  the  books  of  the  bank 
with  regard  thereto;  and, 

(d)  whether,  in  their  opinion,  the  statement 

referred  to  in  the  report  is  properly 
drawn  up  so  as  to  exhibit  a  true  and 
correct  view  of  the  state  of  the  bank's 
affairs  according  to  the  best  of  their 


278      ACCOUNTING    PRACTICE    AND    PROCEDURE 


Attached 
to  annual 
statement 
and  read. 


Audit  and 
report  on 
further 
statements. 


Particulars. 


Attached  to 
statement 
and  read. 


Copies. 


Examina- 
tion by 
auditor 
appointed 
by  Minister. 


information  and  the  explanations  given 
to  them,  and  as  shown  by  the  books  of 
the  bank. 

21.  The  auditors'  report  shall  be  attached  to 
the  statement  submitted  by  the  directors  to  the 
shareholders  under  section  54  of  this  Act,  and 
the  report  shall  be  read  before  the  shareholders 
in  the  annual  general  meeting. 

22.  Any  further  statement  of  the  affairs  of 
the  bank  submitted  by  the  directors  to  the 
shareholders  under  section  55  of  this  Act  shall 
be  subject  to  audit  and  report,  and  the  report 
of  the  auditors  thereon  shall  state — 

(a)  whether  or  not  they  have  obtained  the 
information  and  explanation  they  have 
required; 

(&)  whether,  in  their  opinion,  such  further 
statement  is  properly  drawn  up  so  as  to 
exhibit  a  true  and  correct  view  of  the 
affairs  of  the  bank,  in  so  far  as  the  by- 
law requires  a  statement  thereof,  ac- 
cording to  the  best  of  their  information 
and  the  explanations  given  to  them, 
and  as  shown  by  the  books  of  the  bank. 

23.  The  report  shall  be  attached  to  the  fur- 
ther statement  referred  to  in  the  next  preceding 
subsection,  and  shall  be  read  before  the  share- 
holders at  the  meeting  to  which  such  further 
statement  is  submitted,  and  a  copy  of  the  state- 
ment and  report  shall  be  sent  by  the  directors 
at  and  after  the  meeting  to  any  shareholder  ap- 
plying therefor. 

auditors'  report  to  minister 

56A.  The  Minister  may  direct  and  require 
any  auditor  appointed  under  the  next  preceding 
section  of  this  Act,  or  any  other  auditor  whom 
he  may  select,  to  examine  and  inquire  specially 
into  any  of  the  affairs  or  business  of  the  bank, 


APPENDIX 


279 


and  the  auditor  so  appointed  or  selected,  as  the 
case  may  be,  shall,  at  the  conclusion  of  his  ex- 
amination and  inquiry,  report  fully  to  the  Min- 
ister the  results  thereof. 

2.  For    the    purposes    of    this    section    the  Powers  of 
auditor  appointed  or  selected  as  aforesaid  shall  ^"^'^or. 
have  all   the  rights   and   powers   given   to   an 
auditor  under  the  next  preceding  section. 

3.  For  the  performance  of  the  duties  im- 
posed by  this  section  the  auditor  shall  be  paid  as 
remuneration,  out  of  the  Consolidated  Revenue 
Fund,  such  sum  as  the  Governor  in  Council  may 
direct. 

4.  The  person  selected  by  the  Minister  un-  To  be 
der  this  section  shall,  for  the  purposes  of  section  g^^^^^ 
153  of  this  Act,  be  deemed  to  be  an  auditor  of  of  bank, 
the  bank. 


Remunera- 
tion. 


APPENDIX    VI 

FORM  OF  GENERAL  BALANCE  SHEET  STATE- 
MENT AS  PRESCRIBED  BY  THE  INTER- 
STATE COMMERCE  COMMISSION 
FOR  STEAM  ROADS 

ASSETS 
Investments : 

Investment  in  Road  and  Equipment 

Improvements  on  Leased  Railway  Property 

Sinking  Funds 
Total  Book  Assets  at  Date  (in  short  column) 
Carrier's  Own  Issues  at  Date  (in  short  column) 
Other  Assets  at  Date  (in  long  column) 

Deposits  in  Lieu  of  Mortgaged  Property  Sold 
Total  Book  Assets  at  Date  (in  short  column) 
Carrier's  Own  Issues  at  Date  (in  short  column) 
Other  Assets  at  Date  (in  long  column) 

Miscellaneous  Physical  Property 

Investments  in  Affiliated  Companies; 

(a)  Stocks 

(b)  Bonds 

(c)  Notes 

(d)  Advances 
Other  Investments: 

(a)  Stocks 

(b)  Bonds 

(c)  Notes 

(d)  Advances 

(e)  Miscellaneous 

Total 
Current  Assets: 
Cash 

Demand  Loans  and  Deposits 
Time  Drafts  and  Deposits 
Special  Deposits 

280 


APPENDIX  281 

Total  Book  Assets  at  Date  (in  short  column) 
Carrier's  Own  Issues  at  Date  (in  short  column) 
Other  Assets  at  Date  (in  long  column) 

Loans  and  Bills  Receivable 

Traffic  and  Car-Service  Balances  Receivable 

Net  Balance  Receivable  from  Agents  and  Conductors 

Miscellaneous  Accounts  Receivable 

Material  and  Supplies 

Interest  and  Dividends  Receivable 

Rents  Receivable 

Other  Current  Assets 
Total 

Deferred  Assets: 

Working  Fund  Advances 
Insurance  and  Other  Funds 
Total  Book  Assets  at  Date   (in  short  column) 
Carrier's  Own  Issues  at  Date  (in  short  column) 
Other  Assets  at  Date  (in  long  column) 
Other  Deferred  Assets 
Total 

Unadjusted  Debits: 

Rents  and  Insurance  Premiums  Paid  in  Advance 

Discount  on  Capital  Stock 

Discount  on  Funded  Debt 

Property  Abandoned  Chargeable  to  Operating  Expenses 

Other  Unadjusted  Debits 

Securities  Issued  or  Assumed — Unpledged   (in  short  column 

only) 
Securities  Issued  or  Assumed — Pledged  (in  short  column  only) 
Total 

LIABILITIES 

Stock : 

Capital  Stock 
Book  Liability  at  Date  (in  short  column) 
Held  by  or  for  Carrier  at  Date  (in  short  column) 
Actually  Outstanding  at  Date  (in  long  column) 
Stock  Liability  for  Conversion 
Premium  on  Capital  Stock 
Total 


282         ACCOUNTING  PRACTICE  AND   PROCEDURE 

Governmental  Grants: 

Grants  in  Aid  of  Construction 

Long  Term  Debt : 

Funded  Debt  Unmatured 

Book  Liability  at  Date   (in  short  column) 

Held  by  or  for  Carrier  at  Date  (in  short  column) 

Actually  Outstanding  at  Date   (in  long  column) 

Receiver's  Certificates 

Non-Negotiable  Debt  to  Affiliated  Companies : 

(a)  Notes 

(b)  Open  Accounts 

Total 

Current  Liabilities: 

Loans  and  Bills  Payable 
Traffic  and  Car-Service  Balances  Payable 
Audited  Accounts  and  Wages  Payable 
Miscellaneous  Accounts  Payable 
Interest  Matured  Unpaid 
Dividends  Matured  Unpaid 
Funded  Debt  Matured  Unpaid 
Unmatured  Dividends  Declared 
Unmatured  Interest  Accrued 
Unmatured  Rents  Accrued 
Other  Current  Liabilities 
Total 

Deferred  Liabilities: 

Liability  for  Provident  Funds 
Other  Deferred  Liabilities 
Total 

Unadjusted  Credits: 
Tax  Liability 

Premium  on  Funded  Debt 
Insurance  and  Casualty  Reserves 
Operating  Reserves 
Accrued  Depreciation — Road 
Accrued  Depreciation — Equipment 


APPENDIX 

Accrued  Depreciation — Miscellaneous  Physical  Property 
Other  Unadjusted  Credits 
Total 

Corporate  Surplus: 

Additions  to  Property  through  Income  and  Surplus 

Funded  Debt  Retired  through  Income  and  Surplus 

Sinking  Fund  Reserves 

Miscellaneous  Fund  Reserves 

Appropriated  Surplus  Not  Specifically  Invested 

Total  Appropriated  Surplus 
Profit  and  Loss — Balance 
Total  Corporate  Surplus 


283 


APPENDIX    VII 

TENTATIVE  FORM  OF  BALANCE  SHEET  PRO- 
POSED BY  FEDERAL  RESERVE  BOARD 
FOR  MERCHANTS  AND  MANU- 
FACTURERS 

ASSETS 
Cash: 

I  a.    Cash  on  Hand — currency  and  coin  $ 

lb.    Cash  in  Bank $ 


Notes  and  Accounts  Receivable: 

3.    Notes  Receivable  of  Customers  on 

Hand  (not  past  due) 

5.  Notes  Receivable  Discounted  or 
Sold  with  Indorsement  or  Guar- 
anty    

7.    Accounts     Receivable,     Customers 

(not  past  due) 

9.    Notes  Receivable,  Customers  (past 

due ;  cash  value,  $ )   

II.    Accounts     Receivable,     Customers 

(past  due;  cash  value  $ ) 

Less: 

13.    Provisions     for     Bad 

Debts  $ 

15.  Provisions  for  Dis- 
counts, Freights,  Al- 
lowances, etc 


Inventories : 

17.    Raw  Material  on  Hand.. 

19.    Goods  in  Process 

21.    Uncompleted  Contracts.  ^ 
Less  —  Payments     on 
Account  thereof... 
23.    Finished  Goods  on  Hand. 


284 


APPENDIX  285 

Other  Quick  Assets  (describe  fully)  : 


Total  Quick  Assets  (excluding 
all  investments) 

Securities : 

25.  Securities  Readily  Marketable  and 
Salable  Without  Impairing  the 
Business    

27.  Notes  Given  by  Officers,  Stock- 
holders, or  Employees 

29.  Accounts  Due  from  Officers,  Stock- 
holders, or  Employees 

Total  Current  Assets 

Fixed  Assets : 

31.    Land  Used  for  Plant 

33.    Buildings  Used  for  Plant 

35.    Machinery    

37.    Tools  and  Plant  Equipment 

39.    Patterns  and   Drawings 

41.    Office  Furniture  and  Fixtures.... 
43.    Other   Fixed  Assets,   if   any    (de- 
scribe  fully) 


Less: 
45.    Reserves  for  Depreciation 

Total  Fixed  Assets 

Deferred  Charges: 

47.    Prepaid     Expenses,     Interest,     In- 
surance, Taxes,  etc 

Other  Assets   (49) 

Total   Assets 


286         ACCOUNTING   PRACTICE  AND   PROCEDURE 


LIABILITIES 
Bills,  Notes,  and  Accounts  Payable: 
Unsecured  Bills  and  Notes : 

2.  Acceptances  Made  for  Merchan- 
dise or  Raw  Material  Pur- 
chased     $ 

4.    Notes  Given  for  Merchandise  or 

Raw  Material  Purchased 

6.  Notes  Given  to  Banks  for  Money- 
Borrowed   

8.    Notes  Sold  Through  Brokers 

10.  Notes  Given  for  Machinery,  Ad- 
ditions to  Plant,  etc 

12.  Notes  Due  to  Stockholders,  Offi- 
cers, or  Employees $ . 

Unsecured  Accounts: 

14.    Accounts  Payable  for  Purchases 

(not  yet  due) $ 

16.    Accounts  Payable  for  Purchases 

(past  due) 

18.  Accounts  Payable  to  Stockhold- 
ers, Officers,  or  Employees 

Secured  Liabilities: 

20a.    Notes  Receivable  Discounted 

or  Sold  with  Indorsement  or 
Guaranty   (contra) ,...  $ 

20b.    Customers'     Accounts     Dis- 
counted or  Assigned  (contra)      

20C.    Obligations    Secured   by   Liens 

on  Inventories 

2od.    Obligations  Secured  by  Securi- 
ties Deposited  as  Collateral 

22.    Accrued   Liabilities    (interest, 

taxes,  wages,  etc.) 

Other  Current  Liabilities  (describe  fully)  : 

$ 


Total  Current  Liabilities. 


APPENDIX  287 


Fixed  Liabilities: 

24.    Mortgage  on  Plant  (due  date  . . . . ) 
26.    Mortgage    on    Other    Real    Estate 

(due  date  . . . . ) 

28.    Chattel    Mortgage    on    Machinery 

or  Equipment  (due  date  ....).. 

30.    Bonded  Debt  (due  date  ....).... 

32.    Other   Fixed  Liabilities    (describe 
fully)  : 


Total  Liabilities. 


Net  Worth : 
34.    If  a  Corporation — 

(a)  Preferred  Stock  (less  Stock 

in  Treasury) 

(b)  Common   Stock  (less  Stock 

in  Treasury) 

(c)  Surplus     and     Undivided 

Profits   


Less : 

(d)  Book    Value    of 

Good-Will   ....  $. 

(e)  Deficit    


Total 


36.    If  an  Individual  or  Partnership — 

(a)  Capital    

(b)  Undistributed   Profits   or 

Deficit  


Total    $. 


INDEX 

Account, 

income,  and  consolidated  balance  sheet,  176 
profit  and  loss,  33,  47,  55-74  (See  also  "Profit  and  Loss") 
Accountant,  duties  and  responsibilities  of,  212-248 
in  respect  of  audit,  231-240 

audit  certificates,  responsibility  for,  236 

Canadian  practice,  235 

company  audits,  American  and  English  practice,  235 

English  practice,  231,  235 

moral  and  legal  responsibility,  240 

qualified  certificates,  239 
in  respect  of  liquidation  and  reconstruction,  240-248 

insolvency, 

conditions  leading  up  to,  242 
responsibility  of  accountant,  241 

liquidation  refforts,  241 

reorganization,  245 
in  respect  of  prospectus,  213-230 

adjustments,  222 

certificate  of  financial  condition,  227 

certificate  of  profits  without  certificate  of  assets,  228 

depreciation  and  renewals  in  their  relation  to  profits,  221 

English  requirements  as  to  prospectuses,  214 

estimates  of  anticipated  economies,  223 

estimates  of  future  earnings,  224 

fluctuations  of  profits,  217 

interest  in  its  relation  to  profits,  219 

liability  of  certifying  accountant,  230 

necessity  for  accountants'  certificates,  213 

period  to  be  covered  by  prospectuses,  215 

results  for  broken  periods,  219 

salaries  as  affecting  profits,  220 

statements  of  profits,  varying  requirements  of,  222 

treatment  of  unusual  profits  or  losses,  217 
Accountant's  qualifications,  249 

289 


290  INDEX 

Accounting  and  finance,  corporation,  175-189      (See  also  "Corpora- 
tion accounting") 
Accounting  for  holding  companies,  175-184      (See  also  "Holding 

companies") 
Accounts, 
balance  sheet  (See  "Balance  sheet") 
controlling,  21 
English  law  as  to,  259-260 
expense  and  cost,  28 
general  ledger,  29 
impersonal,  14 
personal,  14 
Accounts  and  bills  receivable,  114-116 
Accounts  payable,  miscellaneous,  145 
Accounts  receivable,  as  cause  of  insolvency,  243 
Additions  and  improvements  to  property,  154,  155 

profits  on,  156 
Adjustment  of  inventories  on  transfer  of  business,  188 
Advances,  86 

to  agents,  90 
Agency  and  commission,  profit  and  loss  account,  59 
Agents,  advances  to,  90 

American  practice  as  to  company  audits,  235 
American  rule  as  to  corporate  profits,  72 
Amortization  of  leaseholds,  173 
Analysis, 
of  balance  sheet  assets,  38-41  (See  also  "Assets") 
current  assets,  40 
fixed  assets,  38 
investment  of  reserves,  39 
permanent  investments,  38 
suspense  debits,  41 
working  assets,  39 
of  balance  sheet  liabilities,  41-47  (See  also  "Liabilities") 
capital  stock,  41 
current  liabilities,  43 
depreciation,  44 
funded  and  unfunded  debt,  43 
profit  and  loss,  47 
surplus,  45 

appropriated,  46 
suspense  credits,  45 
Annual  income  charge,  interest  on  bonds,  134-141 
methods  of  determining,  137-141 
varying  conditions  affecting,  135 


INDEX 

Annuity  method  of  providing  for  depreciation,  167,  168 
accumulations,   168 
expenditures,  168 
objections  to  method,  168 
Appropriated  surplus,  46 
Appropriations,  149  (See  also  "Reserves") 
Assets,  balance  sheet,  34-41,  75-126 
analysis  of,  38-41 
capital  assets,  75-88 
fixed  property,  75-82 

buildings  and  structures,  11 
changes  in  value  of,  80 
furniture  and  fixtures,  78 
land  and  improvements,  76 
movable  equipment,  78 
patents,  goodwill  and  franchises,  19 
patterns,  draw^ings,  dies,  etc.,  78 
plant,  machinery  and  fixed  tools,  11 
investment  of  reserves,  87 
permanent  investments,  82-87 
advances,  86 

investments  for  purposes  of  control,  83,  85 
minor  investments,  85 
non-income  producing  investments,  86 
current  assets,  40,  93-126 

accounts  and  Dills  receivable,  114-116 

present  values,  115 
cash,  118-120 
on  current  account,  119 
outstanding  cheques,  119 
restricted  cash  balances,  120 
foreign  exchange,  120-126 

dealings  in,  125 
investments,  116-118  '   ' 

issued  stock  or  bonds  in  treasury,  117 
unissued  stock  or  bonds,  116 
valuation  of  investments,  117 
life  insurance  company,  118 
stocks  on  hand,  93-114 
book  inventories,  108 

physical  verification  of,  110 
carrying  charges,  treatment  of,  106 
contracts  of  purchase,  112 
cost  accounting,  99 


291 


292  INDEX 

Assets,  balance  sheet   (Continued) 
Current  assets  (Continued) 
Stocks  on  hand  (Continued) 

distribution  of  expense  burden,  100 
expenses,  allocation  of,  102 
increasing  value  of  seasoning  material,  104 
interest,  status  of,  103 
inventory  credits  and  liabilities,  112 
inventory,  taking  the,  96 
inventory  valuations,  accuracy  of,  113 
monthly  charges,  111 

profits,  essentials  for  ascertaining  correct,  96 
profits  on  work  in  progress,  106 
reserves  for  contingencies,   108 
selling  expenses  as  part  of  cost,  102 
fixed  assets,  38  (See  also  "Fixed  property"  above) 
investment  of  reserves,  39,  87 
order  of,  36 
permanent   investments,  38   (See  also  "Permanent  investments  ' 

above) 
working  assets,  39,  88-92 
advances  to  agents,  90 
expenses  incurred  in  advance  of  accrual,  91 

royalties,  92 
stores  and  supplies,  89 
Assets, 

certificate  of  profits  without  certificate  of,  228 
current,  losses  on,  187 
guarantee  of,  223 
Audit, 

accountant's  duties  and  responsibilities,  231-240 
audit  certificates,  responsibility  for,  236 
Canadian  practice,  235 

company  audits,  American  and  English  practice,  235 
English  practice,  231,  235 
moral  and  legal  responsibility,  240 
qualified  certificates,  239 
English  law  as  to,  251-257 
shareholders',  Canadian  Bank  Act,  272-279 


B 


Balance  sheet,  31-54 
accounts,  33 
an  approximation,  31 


INDEX 

Balance  sheet  (Continued) 

assets,  analysis  of,  38-41  (See  also  "Assets") 

current  assets,  40 

fixed  assets,  38 

investment  of  reserves,  39 

permanent  investments,  38 

suspense  debits,  41 

working  assets,  39 
consolidated,  176-184 

and  income  account,  176 

legal  status  of,  179 

other  forms,  183 
English   requirements,    48 
financial  statement,  condensed,  50 
forms  of,  34,  48 

proposed  for  merchants  and  manufacturers,  284-287 

statutory,  51 
steam  roads,  280-283 
liabilities,  analysis  of,  41-47  (See  also  "Liabilities") 
capital  stock,  41 
current  liabilities,  43 
depreciation,  44 
funded  and  unfunded  debt,  43 
profit  and  loss,  47 
surplus,  45 

appropriated,  46 
suspense  credits,  45 
misleading  statements  in,  49 
net  worth,  causes  affecting,  33 
order  of  assets  and  liabilities,  36 
Bank  loans,  current,  144 

manner  of  repayment,  characteristic  of,  144 
Banks,  profit  and  loss  account,  60 
Bills,  discounted,  146 
Bills  receivable,  114-116 
Bonds,  116-118,  133-143 
annual  income  charge,  134-141 
methods  of  determining,  137-141 
varying  conditions  affecting,  135 
discounts  and  premiums  on,  66,  134,  135,  142 
interest  rate  on,  66,  134-141 
issued,  held  in  treasury,  117 
of  life  insurance  company,  valuation  of.  118 
unissued,  116,  I4i 


293 


294  ^^^^^ 

Book  inventories,  108 

physical  verification  of,  110 
Bookkeeping,  13-30 

controlling  accounts,  21 

double-entry,  13 

early  bookkeeping  methods,  17 

impersonal  accounts,  14 

loose-leaf  records,  22,  23 

mechanical  aids  in  bookeeping,  23 

modern  bookkeeping  methods — pro  forma  system,  23-30 

cash  records,  25 

creditors'  or  purchase  records,  27 

expense  and  cost  accounts,  28 

general  ledger  accounts,  29 

journal  entries,  29 

passing  bills  for  payment,  26 

sales  and  customers'  records,  23 
opening  the  books,  15 
personal  accounts,  14 
progress  of  bookkeeping,  30 
subsidiary  ledger,  18,  29 
trial  balance,  16 
Books, 

cash  book,  25 
cost  ledger,  28 
expense  analysis  book,  28 
loose-leaf  or  card  ledger,  22,  23 
opening  the,  15 
voucher  record,  26 
Borrowing,  excessive,  as  cause  of  insolvency,  243 
Buildings  and  structures,  11 
Burden,  expense,  100,  196 


Canadian  audit  practice,  235 

Canadian  Bank  Act,  requirements  as  to  shareholders'  audit,  272-279 

Capital  assets,  75-88  (See  also  "Assets") 

Capital  invested,  comparisons  between  production  and,  208 

Capital  outlay,  interest  and  overhead  charges  as  part  of,  155 

Capital,  payment  of  interest  out  of,  English  rule,  270,  271 

Capital  resources,  available,  143 

Capital  stock  (See  "Stock,  capital") 

Card  ledger,  22,  23 


INDEX  295 

Cash,  118-120 

on  current  account,  119 

outstanding  cheques,  119 

restricted  cash  balances,  120 

statement  of,  in  a  balance  sheet,  118 
Cash  book,  25 
Certificate,  accountant's, 

audit, 
accountant's  responsibility  for,  236,  240 
qualified,  239 

liability  of  accountant  for,  230 

necessity  for,  213 

of  anticipated  economies,  223 

of  financial  condition,  227 

of  future  earnings,  224 

of  profits,  222 
without  certificate  of  assets,  228 
Charges, 

annual  income,  134-141 

carrying,  106 

interest  (See  "Interest") 

monthly,  for  material.  111 

rental,  203 
Cheques, 

outstanding,  119 

voucher,  26 
Classification, 

of  activities  in  respect  to  profit  and  loss,  56-62 

of  assets  and  liabilities,  36 

of  maintenance  expenditures,  162 

of  property  expenditures,  154 
Combination  method  of  providing  for  depreciation,  168,  170 
Commercial  costs,  constituent  elements  of,  195 
Commercial  investments,  200 
Commercial  paper,  144 

Commission  business,  profit  and  loss  account,  59 
Consolidated  balance  sheet,  176-184 

and  income  account,  176 

legal  status  of,  179 

other  forms,  183 
Constituent  companies,  182 
Construction  work,  153-158 

issue  of  shares  for,  English  rule,  158 

profits  on,  156 


296 


INDEX 


Contingencies,  reserves  for,  108 
Contingent  liabilities,  145 
Contracts, 
effect  of  terms  on  costs,  211 
liability  under,  for  labor  or  goods,  146 
of  purchase,  112,  147,  188 

adjustment  of  inventories,  188 
percentages  retained  on,  144 
Control,  investments  for  purposes  of,  83,  85 
Controlling  accounts,  21 
Corporate  profits,  68-74 
American  rule,  72 
English  rule,  68 
general  rule,  73 
Corporation  accounting  and  finance,  175-189 
accounting  for  holding  companies,  175-184 

consolidated  balance  sheet  and  income  account,  176 
constituent  companies,  definition  of,  182 
intercompany  profits  and  accounting,  180 
legal  status  of  consolidated  balance  sheet,  179 
other  forms  of  consolidated  statements,  183 
organization  of  holding  corporation,  questions  arising,  186-189 
adjustment  of  inventories  on  transfer  of  business,  188 
initial  surplus,  186 

losses  on  current  assets  acquired,  187 
profits  earned  before  date  of  consolidation,  185 
Cost  accounting,  theories  and  problems  in,  99,  190-211 

comparisons  between  production  and  capital  invested,  208 
conditions  affecting  cost,  193 
constituent  elements  of  commercial   costs,    195 
constituent  elements  of  manufacturing  cost,  192 
cost  as  a  price  basis,  211 
distribution  of  overhead  expense,  196 
elements  of  manufacturing,  190 
importance  of  accurate  cost  keeping,  199 

interest  and  rent,  relation  to  manufacturing  cost,  200,  201,  204 
interest,  suggested  treatment  in  connection  with  costs,  206 
nature  of  commercial  investments,  200 
nature  of  plant,  191 

profit-sharing  in  its  relation  to  costs,  210 
purposes  of  cost  accounting,  194 
rental  charges,  203 
selling  costs,  102,  198 
Cost  ledger,  28 


INDEX  297 

Credits, 

principles  involved,  14 

suspense,  45 
Current  assets,  40,  93-126  (See  also  "Assets") 
Current  liabilities,  43,  143 

bank  loans  and  commercial  paper,  144 

miscellaneous  accounts  payable,  145 

percentages  retained  on  contracts,  144 

taxes,  145 
Customers'  records,  23 

D 

Debits, 
principles  involved,  14 
suspense,  41 
Debt, 
bonded,  133-143  (See  also  "Bonds") 
funded  and  unfunded,  43 
reserves  for  redemption  of,  148 
Depreciation,  44,  164,  167-174,  221 
methods  of  providing  for,  167-174 
amortization  of  leaseholds,  173 
annuity  method,  167,  168 
combination  method,  168,  170 
diminishing  balance  method,  167,  170 
exhaustion  of  minerals,  172 
interest  on  accumulated  depreciation,  171 
straight  line  method,  167,  169 
relation  to  profits,  221 
Dies,  drawings,  patterns,  etc.,  78 

Diminishing  balance  method  of  providing  for  depreciation,  167,  170 
Discounted  bills,  146 
Discounts  and  premiums, 
on  bonds,  66,  134,  135,  142 
on  stock,  127 
Discounts  on  bonds  not  a  proper  charge  to  capital,  142 
Distribution  of  expense  burden,  100,  196 
Dividends, 
and  reserve,  English  law,  258-260 
distribution, 

American  rule,  72 
English  rule,  68 
general  rule,  73 
in  excess  of  current  earnings,  as  cause  of  insolvency,  244 


298  INDEX 

Double-entry  bookkeeping,  13 
Drawings,  dies,  patterns,  etc.,  78 

Duties  and  responsibilities  of  accountant,  212-248   (See  also  "Ac- 
countant") 

E 

English  audit  practice,  231,  235 
English  law,  extracts  relating  to — 

accounts,  259,  260 

dividends  and  reserves,  258-260 

inspection  and  audit,  251-257 

payment  of  interest  out  of  capital,  270,  271 

prospectuses,  261-269 
English  requirements  as  to — 

balance  sheet,  48 

corporate  profits,  68 

issue  of  shares  for  construction  purposes,  158 

prospectuses,  214 

treasury  stock,  133 
Estimates, 

of  anticipated  economies,  223 

of  future  earnings,  224 
Exchange,  foreign,  120-126 

Expenditures  on  property,  154-174  (See  also  "Property") 
Expense  analysis  book,  28 
Expense  and  cost  accounts,  28 
Expense  burden,  distribution  of,  100,  196 
Expenses  (See  also  "Cost  Accounting") 

allocation  of,  102 

incurred  in  advance  of  accrual,  91 

selling,  as  part  of  manufacturing  cost,  102 

F 
Failure,  business,  duties  and  responsibilities  of  accountant  in  case 

of,  240-245 
Federal  Reserve  Board, 
balance  sheet  proposed  for  merchants  and  manufacturers,  284- 
287 
Finance  and  accounting,  corporation,  175-189  (See  also  "Corpora- 
tion accounting") 
Financial  condition,  certificate  of,  227 
Financial  statement, 
condensed,  50 
steam  roads,  280-283 
varying  purposes  of,  55 


INDEX 

Fixed  assets,  38,  75-82 
buildings  and  structures,  ^^ 
changes  in  value  of,  80 
furniture  and  fixtures,  78 
land  and  improvements.  Id 
movable  equipment,  78 
patents,  goodwill  and  franchises,  79 
patterns,  drawings,  dies,  etc.,  78 
plant,  machinery  and  fixed  tools,  11 

Fixtures,  78 

Fluctuations  of  profits,  217 

Foreign  exchange,  Yl^-Ylb 

Forms  (See  "Statements") 

Franchises,  goodwill  and  patents,  79 

Funded  and  unfunded  debt,  43 

Fund,  sinking,  148 

Furniture  and  fixtures,  78 

Future  earnings,  estimates  of,  224 


General  ledger  accounts,  29 
Goodwill,  patents  and  franchises,  79 
Guarantee  of  assets  or  liabilities,  223 
Guarantees  on  loans,  146 

H 

Holding  companies, 

accounting  for,  175-184 

consolidated  balance  sheet  and  income  account,  176 
constituent  oompanies,  definition,  182 
intercompany  profits  and  accounting,  180 
legal  status  of  consolidated  balance  sheet,  179 
other  forms  of  consolidated  statements,  183 

organization  of  corporation,  questions  arising,  186-189 
adjustment  of  inventories  on  transfer  of  business,  188 
initial  surplus,  186 
losses  on  current  assets  acquired,  187 

profits  earned  before  date  of  consolidation,  185 


Impersonal  accounts,  14 
Improvements,  76,  154,  155,  163,  164 
profits  on,  156 


299 


300  INDEX 

Income,  63 
account,  and  consolidated  balance  sheet,  176 
annual  charge,  interest  on  bonds,  134-141 
methods  of  determining,  137-141 

tables,  140,  141 
varying  conditions  affecting,  135 
Initial  surplus,  186 
Insolvency, 
accountant's  duties  and  responsibilities  in  case  of,  240-245 
causes  or  conditions  leading  up  to,  242 
Intercompany  profits  and  accounting,  180 
Interest, 
and  rent,  relation  to  manufacturing  cost,  200,  201,  204 
charges  in  capital  outlay,  155 
on  accumulated  depreciation,  171 
on  bonds,  66,  134-141 

annual  income  charge,  134-141 
methods  of  determining,  137-141 
varying  conditions  affecting,   135 
payment  of,  out  of  capital,  English  rule,  270,  271 
relation  to  profits,  219 

savings  effected  by  additional  facilities,  206 
status  of,  103 

treatment  of,  in  connection  with  costs,  206 
Interstate  Commerce  Commission, 

statement  prescribed  for  steam  roads,  280-283 
Inventory, 
accuracy  of  valuation,  113 
adjustment  of,  on  transfer  of  business,  188 
book,  108 

physical  verification  of,  110 
credits  and  liabilities,  112 
taking  the,  96 
Investments,  116-118 
commercial,  200 

issued  stock  or  bonds  held  in  treasury,  117 
permanent,  38,  82-87 
advances,  86 

investments  for  purposes  of  control,  83,  85 
minor  investments,  85 
non-income  producing  investments,  86 
reserves,  39,  87 
unissued  stock  or  bonds,  116 
valuation  of,  117 

life  insurance  company,  118 


INDEX  301 


Invoice,  23 

Invoice  card,  26 

Issued  stock  or  bonds  held  in  treasury,  117,  130 

J 

Journal  entries,  29 

Journal  voucher,  23,  29 


Land,  improvements  on,  16  (See  also  "Improvements") 
Leaseholds,  amortization  of,  173 
Ledger, 
expense,  28 

general,  accounts  in,  29 
loose-leaf  or  card,  22,  23 
subsidiary,  18,  29 
Legal  responsibility  of  accountant  as  to  audit  certificates,  240 
Liabilities, 

and  credits,  inventory  of,  112 
guarantee  of,  223 
Liabilities,  balance  sheet,  41-47,  127-152 
analysis  of,  41-47 
appropriations,  149 
available  capital  resources,  143 
bonded  debt,  133-143 

annual  income  charges,  134-141 

varying  conditions  affecting,  135 
discount  on  bond  issues,  142 
effective  interest  rate  on  bonds,  134 

methods  of  determining  annual  charge  to  income,  137-141 
capital  stock,  41,  127-133 
discounts  and  premiums  on,  127 
railway  companies,  requirements  for,   130 
redemption  of,  129 

steamship  companies,  requirements  for,  130 
treasury  stock,  130 
English  rule,  133 
without  par  value,  128 
contingent  liabilities,  145 
bills  discounted,  146 
contracts, 
liability  under  for  labor  or  goods,  146 
of  purchase,  147 
guarantees  on  loans,  146 
shares  not  fully  paid,  146 


202  INDEX 

Liabilities,  balance  sheet  (Continued) 
current  liabilities,  43,  143 
bank  loans  and  commercial  paper,  144 
miscellaneous  accounts  payable,  145 
percentages  retained  on  contracts,  144 
taxes,  145 
depreciation,  44 
funded  and  unfunded  debt,  43 
order  of  liabilities,  36 
profit  and  loss,  47 
secret  reserves,  150 

sinking  fund  reserves  for  redemption  of  debt,  148 
surplus,  45 

appropriated,  46 
Liability  of  certifying  accountant,  230 
Life  insurance  company, 

reserve  for  fluctuations  in  value  of  bonds,  118 
valuation  of  bonds,  118 
Liquidation  and  reconstruction,  accountant's   duties   and   responsi- 
bilities as  to,  240-248  (See  also  "Accountant") 
Loans, 
bank,  current,  144 
guarantees  on,  146 
Loose-leaf  records,  22,  23 
Loss  and  gain  terminology,  55 

suggested,  62 
Losses  due  to  shrinkage  of  current  assets,  187,  242 
Losses  or  profits, 
on  sale  of  property,  65 
unusual,  217 

M 

Machinery,  plant  and  fixed  tools,  11 
Maintenance  expenditures,  159-164 

classification  of,  162 

treatment  of,  by  railroads,  160 
Manufacturing, 

elements  of,  190 

profit  and  loss  account,  57 
Manufacturing  cost, 

as  a  price  basis,  211 

constituent  elements  of,  195 

inclusion  of  rent  as  a,  203 

profit-sharing  in  its  relation  to,  210 

relation  of  interest  and  rent  to,  200,  201,  204 

selling  expenses  as  part  of,  102 


INDEX  303 

Material  (See  "Stock  on  hand") 

Merchandizing  business,  profit  and  loss  account,  58 

Merchants  and  manufacturers,  form  of  balance  sheet  proposed  by 

Federal  Reserve  Board,  284-287 
Methods,  modern  bookkeeping — pro  forma  system,  23-30  (See  also 

"Bookkeeping") 
Methods  of  determining  bond  interest  charges  to  income,  137-141 
operation  of,  138 

table,  140 
when  proportionate  discount  is  written  off,  139 
table,  141 
Methods  of  providing  for  depreciation,  167-174  (See  also  "Depre- 
ciation") 
Minerals,  exhaustion  of,  172 
Mines  and  timber,  expenditures  upon,  76 

N 


Net  worth,  causes  affecting,  32 
Non-income  producing  investments,  86 


Opening  the  books,  15 

Organization  of  holding  corporation,  questions  arising,  186-189 

adjustment  of  inventories  on  transfer  of  business,  188 

initial  surplus,  186 

losses  on  current  assets  acquired,  187 
Outstanding  cheques,  119 

Overhead  and  interest  charges  in  capital  outlay,  155 
Overhead  expense,  distribution  of,  100,  196 


Par  value,  stock  without,  128 

Patents,  goodwill  and  franchises,  79 

Patterns,  drawings,  dies,  etc.,  78 

Payment  of  interest  out  of  capital,  English  rule,  270,  271 

Permanent  investments,  38,  82-87  (See  also  "Investments") 

Personal  accounts,  14 

Physical  verification  of  book  inventories,  110 

Plant,  machinery  and  fixed  tools,  11 

Premiums, 

on  bonds,  66,  134,  135 

on  stock,  128 


304  INDEX 

Private  accounts,  62 

Production,  comparisons  between  capital  invested  and,  208 
Professional  accounts,  61 
Profit  and  loss  account,  33,  47,  55-74 
classification  of  activities,  56-62 

agency  and  commission,  59 

banking,  60 

manufacturing,  57 

merchandising,  58 

private  accounts,  62 

professional  accounts,  61 

transportation,  59 
corporate  profits,  68-74 

American  rule,  72 

English  rule,  68 

general  rule,  7Z 
forms  for  statements  of  loss  and  gain,  63 
items  properly  chargeable  to  profit  and  loss,  65 

discounts  and  premiums  on  bonds,  66 

profits  or  losses  on  sale  of  property,  65 
loss  and  gain  terminology,  55 

suggested,  62 
nature  of  profits,  67 

single-entry  determination  of  profits,  67 
varying  purposes  of  financial  statements,  55 
Profit  and  loss  statement,  63,  222 
Profits, 
certificate  of,  without  certificate  of  assets,  228 
corporate,  68-74 

American  rule,  72 

English  rule,  68 

general  rule,  73 
depreciation  and  renewals  in  their  relation  to,  221 
earned  before  date  of  consolidation,  185 
essentials  for  ascertaining  correct,  96 
fluctuations  of,  217 
intercompany,  180 
interest  in  its  relation  to,  219 
nature  of,  67 

on  construction  work,  156 
on  work  in  progress,  106 
or  losses, 

on  sale  of  property,  65 

unusual,  217 


INDEX 

Profits   (Continued) 

salaries  as  affecting,  220 
singfe-entry  determination  of,  dl 
statements  of,  varying  requirements,  222 
Profit-sharing  in  its  relation  to  costs,  210 
Property, 
fixed,  38,  75-82  (See  also  "Assets") 
profits  or  losses  on  sale  of,  65 
Property  expenditures,  154-174 
classification  of,  154 

interest  and  overhead  charges  in  capital  outlay,  155 
maintenance  expenditures,  159-164 

classification  of,  162 

treatment  of,  by  railroads,  160 
methods  of  providing  for  depreciation,  167-174 

amortization  of  leaseholds,  173 

annuity  method,  167,  168 

combination  method,  168,  170 

diminishing  balance  method,  167,  1/0 

exhaustion  of  minerals,  172 

interest  on  accumulated  depreciation,  171 

straight  line  method,  167,  169 
profits  on  construction  work,  156 
reconstruction  and  improvements,  155 
renewals  and  depreciation,  164 
Prospectus, 

accountant's  duties  and  responsibilities  as  to,  213-230 

adjustments,  222 

certificate  of  financial  condition,  227 

certificate  of  profits  without  certificate  of  assets,  228 

depreciation  and  renewals  in  their  relation  to  profits,  221 

English  requirements  as  to  prospectuses,  214 

estimates  of  anticipated  economies,  223 

estimates  of  future  earnings,  224 

fluctuations  of  profits,  217 

interest  in  its  relation  to  profits,  219 

liability  of  certifying  accountant,  230 

necessity  for  accountants'  certificates,  213 

period  to  be  covered  by  prospectuses,  215 

results  for  broken  periods,  219 

salaries  as  affecting  profits,  220 

statements  of  profits,  varying  requirements  of,  222 

treatment  of  unusual  profits  or  losses,  217 
English  law  as  to,  261-269 


305 


3o6  INDEX 

Purchase, 
contracts  of,  112,  147,  188 

records,  27 

Q 

Qualifications  of  accountant,  249 
Qualified  certificates,  239 

R 

Railroads, 

requirements  as  to  treasury  stock,  130 

treatment  of  maintenance  expenditures  by,  160 
Receipts  from  sales,  cash,  24 

Reconstruction  and  liquidation,  accountant's  duties  and  responsi- 
bilities as  to,  240-248 
Reconstruction  of  property,  155 

profits  on,  156 
Redemption, 

of  debt,  sinking  fund  reserves  for,  148 

of  stock,  129 
Renewals,    repairs,    depreciation,    and    new    construction,    153-174 

(See  also  "Property  expenditures") 
Rent  and  interest,  relation  to  manufacturing  cost,  200,  201,  204 
Rental  charges,  203 
Reorganization,  245 
Repairs,    renewals,    depreciation,    and    new    construction,    153-174 

(See  also  "Property  expenditures") 
Reports  (See  "Statements") 

liquidation,  accountant's,  241 
Reserves, 

difference  between  voluntary  and  necessary,  149 

dividends  and  English  law,  258-260 

for  contingencies,  108 

investment  of,  39,  87 

secret,  150 

sinking  fund,  for  redemption  of  debt,  148 
Responsibilities  and  duties  of  public  accountant,  212-248  (See  also 
"Accountant") 

in  respect  of  audit,  231-240 

in  respect  of  liquidation  and  reconstruction,  240-248 

in  respect  of  prospectus,  213-230 
Responsibility,  accountant's,  for  audit  certificates,  236 

moral  and  legal,  240 
Revenue,  63 


INDEX 


30; 


Royalties,  92 

Rules  of  considering  profits,  68-74 

American  rule,  12 

English  rule,  68 

general  rule,  73 


Salaries  as  affecting  profits,  220 
Sale  of  property,  profits  on,  65 
Sales  and  customers'  records,  23 
Scrap  material,  valuation  of,  99 
Secret  reserves,  150 
Selling  cost,  198 

as  part  of  manufacturing  cost,  102 
Shareholders'  audit,  extracts  from  Canadian  Bank  Act,  272-279 
Shares  (See  "Stock") 
Single-entry,  67 

Sinking  fund  reserves  for  redemption  of  debt,  148 
Statement, 

balance  sheet,  34,  48,  51 
analysis  of  assets,  38 
analysis  of  liabilities,  40 
consolidated,  176-184 

proposed  for  merchants  and  manufacturers,  284-287 
steam  roads,  280-283 
varying  purposes  of,  55 

condensed,  SO 

loss  and  gain,  63 

of  profits,  varying  requirements  of,  222 
Steam  roads,  statement  prescribed,  280-283 
Steamship  companies,  requirements  as  to  treasury  stock,  130 
Stock,  capital,  41,  117,  127-133,  143,  146 

discounts  and  premiums  on,  127 

issued,  held  in  treasury,  117 

not  fully  paid,  146 

redemption  of,  129 

treasury,  130 
English  rule,  133 

unissued,  116,  143 

without  par  value,  128 
Stock  on  hand,  93-114,  243 

as  cause  of  insolvency,  243 


3o8  INDEX 

Stock  on  hand  (Continued) 

book  inventories,  108 

physical  verification  of,  110 

carrying  charges,  treatment  of,  106 

contracts  of  purchase,  112 

cost  accounting,  99 

distribution  of  expense  burden,  100 

expenses,  allocation  of,  102 

increasing  value  of  seasoning  material,  104 

interest,  status  of,  103 

inventory  credits  and  liabilities,  112 

inventory,  taking  the,  96 

monthly  charges,  111 

profits,  essentials  for  ascertaining  correct,  96 

profits  on  work  in  progress,  106 

reserves  for  contingencies,  108 

selling  expenses  as  part  of  cost,  102 
Stores  and  supplies,  89 

Straight  line  method  of  providing  for  depreciation,  167,  169 
Subsidiary  cash  book,  25 

Subsidiary  companies  (See  "Holding  companies") 
Subsidiary  ledgers,  18,  29 
Supplies  and  stores,  89 
Surplus,  33,  45,  63 

appropriated,  46 

initial,  186 
Suspense  credits,  45 
Suspense  debits,  41 
System  (See  "Method") 


Tables,  annual  charge  to  income,  140,  141 

Taxes,  145 

Terminology,  loss  and  gain,  55 

suggested,  62 
Theories  and  problems  in  cost  accounting,  190-211  (See  also  "Cost 

Accounting") 
Tools,  fixed,  n 

Transportation,  profit  and  loss  account,  59 
Treasury  stock,  117,  130,  133 
Trial  balance,  16 

U 

Unfunded  debt,  43 

Unissued  stock  or  bonds,  116,  143 


INDEX  309 


V 

Valuation, 

of  inventory,  113 

of  investments,  117 
life  insurance  company,  118 

of  stock  on  hand,  93-114 
Voucher,  25 

journal,  23,  29 
Voucher  cheque,  26 
Voucher  record,  26 

W 

Work  in  progress,  valuation  of,  98 

Working  assets,  39,  88-92  (See  also  "Assets") 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 

Los  Angeles 

This  book  is  DUE  on  the  last  date  stamped  below. 


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APR  1  8  1962 

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APR  2  4  1975 

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